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An article published yesterday in the Wall Street Journal made the case that investors are turning a deaf ear to earnings alarms. Expectations for earnings as projected by analysts have been marked down significantly in recent months. In fact, consensus earnings expectations for Q3 of 2012, if realized, will mark the first quarter since the great recession in which earnings have declined. The decline is small and expected to be approximately -1%. Incidentally, last quarter showed barely any earnings growth and the article implicitly makes the argument that negative one percent is somehow much different than positive one percent.

Since the second quarter of 2009 we have been graced with a remarkable earnings-led bull market as the economy rebounded from the depths of the Great Recession and earnings growth turned positive. Of course, the bull market began two quarters before the rebound in earnings. As is typically the case, the market anticipated rebounding earnings approximately six months before they were actually reported. Thus, it is far more likely in the coming earnings season that guidance will be the deciding factor rather than earnings, unless earnings are weaker than expected.

Figure 1: Earnings Growth Since Q4 2009.

An important question for investors to ask themselves is this: Is a flat year of earnings correlated with stock market declines in the following year? Logically, if you take the fact that earnings are flat year over year and use that as a decision to leave the market, then you should expect historically that flat years of earnings growth preceded stock market declines. Otherwise, you are using a false signal to try to time the market.

Below is a graph of the real earnings of the S&P 500 since 1887 courtesy of Multpl.com. As you can see, earnings are quite volatile. They can go down slightly and then go up again. What everyone is afraid of is the V-shaped collapse and then rebound of earnings in 2008. Certainly a collapse in earnings would be very bad for stock prices. However, look at all the years that have been flat or slightly down over the past 120 years. Is it logical to sell every time there is a flat year?

Figure 2: Real Earnings for the S&P 500 Since 1887.

click to enlarge images

Conveniently the data for earnings was also available in table form. After transferring the data to a spreadsheet it was easy to analyze years since 1887 and compare earnings growth in one calendar year with stock market returns in the next. Below is a scatter plot of those two variables. The x-axis is the growth in earnings from one year to the next (say 1987 to 1988) and the y-axis is the stock market return for the following year (1988 to 1989 in this case). There was no correlation whatsoever for these two variables.

Figure 3: Earnings Versus the Next Year's Stock Market Return.

Perhaps there was no correlation because it is only when earnings growth has slowed prior to rolling over that earnings growth matters. This assumes that there is something special about zero or near zero earnings growth and that the next year after zero earnings growth statistically should be a bad one. In the next chart, the rate of earnings growth versus the next year return was analyzed for only years in which the prior year earnings growth was between 5% and -5%. Again, there is no correlation with the subsequent stock market return.

Figure 4: Earning Versus the Next Year's Return When Earnings Growth Was Low.

Interestingly, the average return of years when the growth was between -5% and 5% was higher for the subsequent year than when all years were included (4.4% vs. 3.5%). This could simply be statistical noise, but the point remains that if there is any correlation with zero earnings growth it is for higher than average returns in the following year.

The problem with analyzing the stock market this way stems from the fact that the market is a discounter of widely known information. Thus if earnings are expected to be lower, it is only the difference from that lowered expectation that causes an investor to buy or sell. Earnings are volatile, they move up and down, but the only way to time the market based on earnings is if you know when they will come in below expectations. There are cases to be made for why this could be the case, but saying earnings will go down because they are flat year over year is not a good argument.

Source: The Worst Earnings Season Since 2009: Should Investors Be Worried?