Deciding Which Earnings Reports to Follow

Here we compare S&P500 (SPY) earnings results with those of the general market. Figure 1 shows S&P earnings since the rally began in March 2003. Note the drops in the slope of successive trend support lines as the rate of earnings improvements decelerated then the final break as earnings began to weaken in early February 2008.

Graph of S&P earnings from VectorVest showing earnings peaking in the first week of January

But this chart also exposes the clear deceleration that began to occur in earnings as early as June 2006 when the first trendline (left) was broken. The breach of the next trendline didn’t occur until mid-December but then S&P earnings briefly re-energized only to be broken again in mid-February (third blue trendline) and at orange arrow in lower subgraph. Chart by VectorVest.com

Now contrast this performance with quarterly earnings improvements (compared to the same quarter the year before) as reported for the more than 4000 companies reported in the Wall Street Journal. We got our first real warning that earnings were dropping way back in Q1-07 with the big decrease in earnings from Q4-06. The annual earnings rate of change then turned negative in October 2007 and has continued to do so through Q4-07 reporting season.

As we come into the Q4-07 earnings reporting season home stretch, a total of 3997 companies have reported so far (up from 3596 last week) and quarterly earnings improvements dropped again to -57% (from -56% last week and -55% two weeks ago) compared to the quarter the year before leaving little doubt that earnings continue to deteriorate across the board. This compares to a drop of 21% (4205 companies) at the end of Q3-07 reporting season and a 13% jump in Q2-07.

Chart showing earnings improvements for more than 4000 companies tracked by the Wall Street Journal.

Note that we got the first warning that improvements were declining in Q4-07 in late October – a good four months before S&P earnings in Figure generated a similar warning. As of the latest data, average Q4-07 earnings are deteriorating rapidly.

This is a clear indication why it is better to follow the broader market versus the cherry picked S&P500 or any major index for that matter since these companies change as the market changes. It is why analysts focusing on S&P earnings have been behind the eight ball when it came to seeing the slowdown.