After one of the calmest equity markets on record, volatility spiked in early February and has increased periodically since. Now there seem to be concerns coming from many different angles affecting the markets, so how do investors know what will ultimately drive returns? The answer is simple and rooted in fundamentals: earnings and valuations.

Corporate profit growth is a good predictor of returns over time. In fact, since 2004, returns for the S&P 500 moved alongside reported earnings, in both up and down markets (Display). This trend can be explained by understanding the drivers of a company’s worth.

UNDERSTANDING WORTH

A company’s market value typically comes from current earnings and the potential for future growth of those earnings. As earnings rise or are expected to grow, market values generally do, too. However, reported earnings are not the only factor; market values are also influenced by what multiple investors are willing to pay for those earnings. Nonetheless, over the long term, robust reported earnings and expected future growth typically lead to higher market values and stronger returns. But there can be lags between reported earnings and market returns; they do not perfectly overlap. Regardless of intermittent separation, the connection between earnings growth and market returns is strong.

CONTINUED EARNINGS GROWTH?

Last year, both were strong, although returns outpaced earnings growth. Earnings grew nearly 11% in the US, 24% in developed-international markets, and 29% in emerging markets, corresponding with market returns of roughly 22%, 25%, and 37%, respectively. Returns continued their upward move in January as robust fourth-quarter results were reported. In fact, 86% of large US companies beat or met industry analysts’ earnings estimates, driving market returns precipitously higher. 2018 is shaping up to be another solid year for earnings. Corporate profit growth is forecast to be about 20% in the US, while outside the US, it’s anticipated to reach the mid-teens. Part of the growth in the US is coming from the recent tax legislation, which has contributed to consensus growth estimates that have moved up about 8% since the passage of the bill. That said, investors are now also looking beyond 2018 and into 2019. We expect that growth will naturally decelerate in 2019 from 2018 levels but will remain above trend. This deceleration will likely bring down market returns, but we don’t expect them to fall off a cliff, as growth will continue to be solid.

RATES UP, MULTIPLES DOWN

Another factor that influences market returns is interest rates. We expect rates to continue to normalize higher from the extremely low levels maintained by the Fed since the financial crisis. We anticipate three more Fed rate hikes in 2018 in addition to the increase announced in March, which should raise the Fed’s target range by 1% for the year. Typically, when interest rates are low, markets can support higher valuation multiples, and vice versa. However, the relationship is not linear and we assume that as rates normalize in the years to come, valuations will fall closer to historical norms, which will be a headwind to returns.

PUTTING THE PIECES TOGETHER

Market returns come from three sources—dividend yield, earnings growth, and changes in valuation. The dividend yield of the S&P 500 has been roughly flat—around 2%—since the early 2000s, and we expect dividends to contribute ~2% over the next 10 years. Therefore, earnings growth and multiple expansion are the important variables and will be the primary drivers of overall performance in any given year. Over the next 10 years, we believe that earnings growth will provide 5%–6%, while valuation will detract from returns as multiples contract from current levels.

ROOTED IN FUNDAMENTALS

As with any forecast, especially one that looks many years into the future, market unknowns and surprises can change the outlook. What may seem like smooth sailing can end up being the calm before the storm. That’s why it is always important to understand the uncertainties that can alter expectations. Today those uncertainties are both geopolitical and economic. Markets are precarious, so staying rooted in fundamentals—in this case, following the earnings and valuations—should pave the way to understanding return expectations.

For more on trends in the economy, markets and asset allocation for long term investors, explore The Pulse, a Bernstein podcast series, and for additional thought leadership, check out the related blogs here.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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