While there are a lot of popular explanations for the recent weakness in global equity prices, a far more fundamental driver could be at play: US corporate earnings.  In determining whether the US equity market is on the cusp of another extended bear market – as last seen in 2000-02 and 2007-09 – history suggests it’s only likely to happen if there’s also a down trend in corporate earnings. Ominously, the glorious uptrend in US earnings since the financial crisis is starting to look a little toppy.

Earnings: Necessary and Sufficient Driver of Prices

Although there are many theories peddled as to what drives share prices – including sunspots and fancy technical patterns – there’s one thing we know for sure: prices can’t deviate from underlying corporate earnings for too long. As seen in the chart below, each of the past two major bear markets in the United States – in 2000-02 and 2007-09 was associated with a notable down trend in 12-month forward earnings*.

In view of this history, it’s worth noting that US forward earnings over the past year have again started to look toppy. Indeed, using Bloomberg consensus analyst earnings expectations, the BetaShares estimate of forward earnings for the S&P 500 Index peaked in November 2014.  Forward earnings then fell before staging a mini-come back through 2015, but now look to be rolling over again.

Indeed, as seen in the chart below, there was a notable downgrade to US earnings expectations during January, principally reflecting a much weaker outlook for the energy sector as a result of the collapse in oil prices. Of course, if earnings expectations are not revised further,  then forward earnings could still rise through 2016 as, according to Bloomberg consensus estimates, 2017 earnings are expected to rise by 13% on 2016 levels.  In fact, current earnings expectations imply forward earnings will rise by 13% over the coming 12 months.

That said, US consensus earnings expectations are usually always bullish and bear little relationship to actual earnings performance. Note this is not unique to the United States, but is a general phenomenon in most countries.  As seen in the chart below, actual annual US forward earnings growth has been less than consensus expectations since early 2012 – but annual growth nonetheless remained positive at around 5-10% up until late 2014.  Annual forward earnings growth then started to slow, and little growth has been evident since around February last year.

After a strong run in recent years, higher US interest rates, a higher US dollar, tightening labour markets and deeper retrenchment in the shale oil sector all now pose downside risk to US corporate earnings.  It also remains the case that US profit margins remain at historically higher levels.  If forward earnings do in fact “roll over” this year, recent history suggests it will be hard for equity prices not to follow suit.

Not helping, moreover, is the fact that valuations are also extended, with the price-to-forward earnings ratio ending January at 15.9, compared with a longer-run average of only 14.5. And even against (still low) bond yields, the market is still on the pricey side, given the forward-earnings-to-bond-yield gap (at around 4%) is at the lower end of its range since the financial crisis.

*12-month forward earnings are a rolling weighted average of consensus earnings per share estimates for both the current and following financial year, with the weight attached to the following year increasing (and the weight for the current financial year decreasing) as the new year approaches.  In the case of the United States, for example, forward earnings as at June-2015 would be an equal weighted average of earnings in both the 2015 and 2016 calendar years. By December 2015, forward earnings fully reflected expected earnings for 2016.