Earnings Don't Support A Continued Rally In U.S. Stocks

| About: SPDR S&P (SPY)

Summary

S&P 500 GAAP earnings peaked in 2014, although Pro Forma earnings have increased.

GAAP Earnings tend to peak the year before or the year of a stock market peak.

So far, the S&P 500 price high has been in May 2015.

Currently, earnings don't support a move higher. A fall to the lower end of the current trading range is more likely.

There is a considerable amount of negative opinion on U.S. stocks as the S&P 500 approaches its all-time closing high of 2,130.83 reached on May 2, 2015. The index came close to this value on June 7th with its last trade recorded as 2,119.12. The S&P 500 has actually been trading in a range between approximately 1,800 and 2,130 for over two years now and needs to decisively break either above or below this level to indicate a new up or down trend has begun. Until this happens, the index should be considered as moving sideways in a 300+ point trading band.

S&P 500 Trading History 2011-2016

S&P 5-Yr Trading Range Chart.gif

There are a number of arguments as to why the market is very overvalued and should be going down instead of up. Some of these include a very high price to earnings ratio, a very high price to sales ratio, a very high market cap to GDP ratio, a very high percent of NYSE stocks trading above their 200-day moving average, etc. The best measure of the direction of stock prices, however, is earnings. For the stock market to keep moving forward, earnings must be increasing, and not just any measure of earnings, but GAAP (Generally Accepted Accounting Principles) earnings.

GAAP earnings are consistent and comparable over time, whereas the alternative, pro forma earnings, are fairly arbitrary, vary by industry, and can change from year to year. The basic idea behind pro forma earnings is that unusual events don't count, so they should be ignored when calculating earnings. This is like an individual claiming that they really have much more money in their checking account than the bank claims because they had to write a number of checks for unusual expenses last month and those shouldn't have been deducted from their balance.

Pro forma earnings held up until 2015 (we'll have to wait to see what happens in 2016) thanks to companies becoming increasingly fanciful with their accounting practices. S&P 500 GAAP earnings, however, peaked in 2014 and have been heading down since. They were $100.20 per share in 2013, $102.31 per share in 2014, but only $86.47 per share in 2015 (a significant drop). GAAP earnings in 2011 and 2012 were $86.95 and $86.51 respectively, almost exactly the same as in 2015, yet the price of the S&P 500 has moved much higher. When pro forma earnings and GAAP earnings move in opposite directions, market analysts describe this as a decrease in the quality of earnings (this allows them to avoid using generally accepted obscenities to more graphically state what is occurring).

GAAP earnings tend to peak the year before or the year of a stock market peak. Previously, they topped out in 2006 and the U.S. stock market hit a high in October 2007. It then subsequently fell off a cliff in the fall of 2008. Prior to that, GAAP earnings hit a high in 2000 along with the market. So far, GAAP has peaked in 2014, fallen 15% in 2015 and it doesn't look like 2016 is going to be a great year for earnings, either (they're down approximately 5% in Q1). There are estimates for sizeable earnings increases in the second half of the year, however. Realistically, these could come from improved earnings in the beaten down energy and materials sectors, if they indeed do occur.

Investors should be wary of projections for improved earnings once a substantial decline has taken place in GAAP earnings. Projections are made with the underlying assumption that the economy is growing and there will not be a recession. If there is a recession, S&P 500 GAAP earnings can decline by 50% to 75% or more year over year. For instance, in 2007, GAAP earnings were $66.18 per share, but in 2008, they were only $14.88. It's been seven years since the last U.S. recession. In the post-WWII era, the longest period between U.S. recessions has been 10 years. The average time between them has been only five years. We are already overdue, so a recession beginning as early as the fall of 2016 or any time in 2017 is very possible.

When earnings are deteriorating, but stock prices are going higher, there are two possible explanations. Either a big jump in earnings is being anticipated by the markets or central banks are injecting liquidity into the financial system by more than enough to compensate for the potential decline in stock prices. If the S&P 500 is to break out and go higher, it will be currently be dependent on the Fed maintaining or increasing liquidity, which means no rate increase from them. Any increase, would likely immediately put a damper on an incipient rally.

Currently, risk is more likely to the downside with a return toward the bottom of the trading range. Investors, though, need to pay close attention to price moves. The market will decide where it wants to go. A close that is 2% above the upper end of the trading range, or about 2170 or higher, would indicate a new rally is beginning as long as price stays above that level. Investors can use ETFs such as SPY or DIA to trade the U.S. stock market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.