Earnings Growth Does Not Predict Stock Market Returns

Lots of readers are writing in to question my assertion that the stock market does not track corporate profits or GDP. They seem upset to learn that if you can correctly predict GDP growth or earnings growth in the short term that you can't also predict the direction and magnitude of the market's moves. The key here is that the market prices in certain expectations about the future ahead of time and then readjusts prices based on how the future plays out relative to those expectations. We cannot simply infer that, say, over the next year GDP will grow 3%, leading to earnings growth of 8%, and therefore the market will rise 8%. Markets are more complicated than that!

Here is an illustration I came up with to back up these claims (raw data compiled by NYU from Standard and Poor's and Bloomberg). As you can see, correctly predicting S&P 500 earnings growth (grouped along the x-axis) for any given year does not help predict the market's return (plotted along the y-axis) during that same year. In fact, the market does better when earnings are declining, relative to how it fares when earnings are growing by double digits. In the near future I will try and compile data that shows which figures actually have predictive value.

Record Corporate Earnings Continue to Fuel Stocks, Analysts Optimistic for 2011

According to financial data collected by Thomson Reuters, 70% of S&P 500 index companies have reported third quarter profits so far and earnings are up 30% year-over-year. This compares to estimates of just 24% growth and explains why the U.S. equity market is knocking on the door of the 2010 highs made back in April. For all of the pundits complaining that Washington DC politicians have been bashing Corporate America too much, aggregate corporate profits are actually making new record highs (second quarter earnings were an all-time record) so we have to wonder exactly how tough companies really have it these days.

As we head into 2011 analysts are expecting corporate profits to keep surging, by about 13% next year. With P/E multiples about average historically, the strength of earnings will likely dictate much of market's movement in 2011. Analysts notoriously overestimate profit growth (by a factor of nearly 2x over the long term according to studies done by McKinsey), so once again they are very optimistic about the coming year (corporate profits grow about 6% per year over long periods of time). As is usually the case, the numbers are telling a better story of reality than political and private sector commentators, which is why the market is doing pretty well despite 9.6% unemployment.

To gauge market prospects for next year, investors should continue to look at the numbers and ignore the posturing in the media and on the campaign trail. As things stand now, I would expect another gain for the U.S. equity market in 2011, but the magnitude will depend on whether the analysts are right or once again overly optimistic. That could be the difference between single digit and double digit returns over the next 12-15 months for stocks.

And on a somewhat related note, don't forget to get out and vote tomorrow.

Statistical Shocker: S&P 500 Performs Best When Economy is Shrinking

Impossible, right? As a money manager I spend a decent amount of time explaining to clients, readers, family, and friends that the stock market does not mirror the economy in real time. Just because the unemployment rate is 9.5% and GDP growth is decelerating does not mean that the stock market is a poor investment option. Stock market returns and GDP growth simply do not track each other, and as a result, reading economic reports will not help you figure out where stock prices are headed.

As always, I try to present numbers to people so they do not simply have to take my word for it. In today's world of media sound bytes and political maneuvering Americans all too often repeat something they heard from one of their favorite media or political pundits as if it was fact, even when a tiny bit of research can disprove the claim.

In order to show that stock market movements do not mimic the economy, I decided to compile data from 1958 (the first full year the S&P 500 index was published) through 2009. While I had no idea what the actual numbers would be, I was confident they would show that stocks and the economy shared a very low correlation. Sure enough, the results were even surprising to me. It turns out that the S&P 500 has performed best when GDP growth is actually negative (i.e. when the economy is in a recession). Since 1958 there have been 7 years when U.S. GDP shrank and the S&P 500 gained an average of 24% per year during those periods. Pretty interesting, right?

Here is the full data set. I divided economic growth into 4 subsets (negative, zero to 3%, 3 to 5%, and above 5%).

As you can see, there is very little correlation between the economy and the stock market. Not only that, investors choosing to own stocks only in years with negative GDP growth would have earned nearly 4 times as much than investors choosing to invest only when GDP was growing at 5% or better. So the next time someone tells you the market is going to drop because the economy is bad or unemployment is high, send them a link to this blog post.

S&P 500 Index: Soon To Be The Cheapest Since 1989

The recent swoon in the U.S. stock market has gotten to a point where there are plenty of values to be found for those investors willing to ignore the near-term headlines and negative sentiment. In fact, if things stay where they are for the next quarter or two, the S&P 500 index will be the cheapest it has been in more than 20 years (based on the current 2010 earnings estimate for the index of nearly $82). Below is a chart of the S&P 500's trailing P/E ratio from December 31, 1988 through December 31, 2010 (the P/E for the next six months is an estimate based on current consensus profit expectation, assuming the market stays at today's level).

Source: Standard and Poor's Data

As of today we are at a P/E of about 14 (on this chart, the second to last notch on the x-axis). Assuming stock prices and earnings estimates remain where they are, the U.S. market would end 2010 at its cheapest level since 1989 (12.5 times trailing earnings). I know the headlines have been bleak over the last eight weeks or so, but stocks are quite cheap, especially given low interest rates and tame inflation.

If earnings season is pretty good this quarter (including in-line guidance for the second half of the year), as I expect it to be, I will very likely allocate some additional portfolio cash into the equity market. Although the market chatter is centered around the increased odds of a double-dip recession, it is important to note (as was pointed out on CNBC just this morning) that we have seen only 3 double-dip recessions over the last 150 years. Does that mean it is impossible we could get a fourth? Of course not, it just makes it probably a lot less likely than the U.S. equity market is currently indicating.

WSJ: U.S. Corporations Sitting on Stellar Balance Sheets

From the Wall Street Journal:

"The Federal Reserve reported Thursday that non-financial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest increase on records going back to 1952. Cash made up about 7% of all company assets including factories and financial investments, the highest level since 1963."

The strongest balance sheet backdrop for Corporate America in nearly 50 years can only be a positive for the U.S. stock market. Extra cash for strategic mergers, share repurchases, and dividend payouts can help boost stock prices until businesses become confident enough to invest money back into their own asset bases. The latter likely won't occur until some of the bearish headlines of recent weeks subside. Among the important ones I would highlight, in order of potential resolution, would be the financial regulation bill going through Congress, the Goldman Sachs fraud case brought by the SEC, and the Gulf of Mexico oil spill. Second quarter earnings will likely be quite strong, but the headline risk is trumping fundamentals for the time being.

Rather than Panic About Greece and the Euro, Make a Shopping List

I have been holding double-digit cash positions in most equity client accounts for much of 2010 and this week I began allocating some of that cash back into the market. We finally got a 10% correction, after more than a year without one. The market seems to be obsessed with Europe and the Euro exchange rate right now, but honestly we have to keep things in perspective. Most U.S. companies (excluding the large multinationals of course) are not going to be directly impacted by troubles in Greece and neighboring areas. The entire country of Greece has the same population as the state of Ohio, so that really keeps things in perspective, for me anyway.

Accordingly, I do think U.S. stock prices have come down enough in recent weeks to warrant some bargain hunting. I invested about half of my clients' cash balances this week. It is quite conceivable that the market tests the intra-day low reached on the crazy flash trading/1,000 down day earlier this month (1,065 on the S&P 500) and finds some support there. The sentiment is pretty ugly right now, so although I am still keeping some cash onhand in case of further weakness, I do think it is time to nibble at good values.

My suggestion for investors who share those feelings would be to make a shopping list. Come up with a handful of stocks you would like to own and pick a price that you really feel good about. As the market gyrates, you may be surprised which companies you can grab at very attractive price points. If you are a long term investor, try not to panic. There really are some great deals out there right now, as the S&P 500 has fallen below 1,100 and into correction territory.

What Can Happen When Markets Are Run By Computers? Stock Trading Might Go Nuts Like Today!

This afternoon the U.S. stock market went bananas and I decided to sit down in front of the television, watch, and enjoy myself. When the entire market is run mostly by computers, not only can traders control the minute by minute action but they can even set the computer up so that once certain price levels are reached, their trades get executed automatically, so actual human action is not even necessary. What happens when the computers are overloaded or someone makes a mistake? Well, watch this short segment from CNBC and see how the Dow Jones can drop 500 points and then make it all back in less than five minutes.

This is why many people think short-term trading in the market is nothing more than gambling. Literally anything can happen on any single day, in a single hour or minute, or in this case, a few seconds. Market watchers will tell you to use limit orders as a way to specify your exact desired buy and sell prices to avoid getting taken to the cleaners when markets react violently like this.

The problem with that, of course, is that your order may hit in a moment of panic, and had you known that was happening, you never would have made the trade. Imagine if you came home today to learn that you sold 100 shares of Proctor and Gamble at $50 (a limit order you had set) because it traded there for a brief second based on computer malfunction, but rebounded to $61 within seconds. You would be furious. Limit orders are not always the answer. Investors, especially those who are novices, need to be very careful. As we saw today, the market can be a landmine.

Current Bull Market Now More Than 400 Days Without 10% Correction

For several months I have been holding elevated cash levels (above 10%) in most client accounts, due to the fact that the stock market appears overbought and has gone a very long time without a standard 10% correction. In fact, we have now gone more than a year without a 10% drop which is a long time historically. I decided to look at the data to see exactly how overbought this market is relative to other bull markets.

It turns out that the current streak of more than 400 days without a correction represents only the 14th time this has happened since 1928. Of those instances, the current bull market (up more than 80% from the March 2009 intra-day lows) places fourth on the list. The three stronger bull market streaks (1953-1955, 1990-1996, and 2003-2007) ranged from +97% to +131%.

Depending on your time frame, the current streak could be either alarming or unimportant. One could argue that the fourth longest streak in 82 years indicates near term problems on the way, but one could also conclude that the last streak of this length was only a few short years ago, so maybe it is becoming more and more common.

I prefer to look at the longest set of data we have, which is why I continue to hold above-average cash levels. The fewer data points you consider, the less reliable the data will actually be. This can explain a lot of things in various topics, including why there is such a heated debate about global warming right now. If you look at the last 5 years you might conclude that global warming is no longer happening. Conversely if you look at the temperature trends over the last 100 years, it is pretty obvious that global warming is occurring.

Looking at historical stock market data tells me that the current bull market is near the top of the list historically, but of course that does not mean stocks are going to fall anytime soon. Just three years ago the S&P 500 went 4 years without a 10% correction. Today it has only been a little more than 1 year. As a result, I prefer to hold extra cash to use should the correction come, but still have most of my clients' capital invested in attractively-priced stocks.

Market Is Pricing In 35% Profit Growth in 2010

A theme of mine in recent weeks, as well as for 2010, is that the stock market has risen 70% from the March lows and has begun to price in the current consensus forecast of $75 in S&P 500 earnings, which would be a 35% increase from 2009. As a result, I think the Wall Street strategist consensus of a 10 -15% market gain this year seems overly optimistic. It is far more likely that earnings come in below $75 than above that level.. not a good risk-reward trade off.

Last evening we got the first big earnings report from the fourth quarter (Intel), they blew away the numbers (40 cents vs 30 cent estimate) and the stock is down this morning. JPM reported a decent number this morning (beat on earnings, light on sales) and it is down too. Whenever you see stocks not go up on good news, it is typically a clear sign that the markets have priced in the good news.

Despite a cautious market outlook short term, there are still good investments out there. I will share a couple in coming weeks to halt the post-holiday lull in postings on this site.

Chad Brand Interviewed on "Behind The Spread"

I recently did an interview with the investment site "Behind The Spread" which focused on learning about the backgrounds of various investment professionals.  They are interviewing the genius investors on KaChing and it was my turn in line. If you would like to learn a bit more about me and my investment philosophy, you can check out the Q&A here:

Chad Brand interview on "Behind The Spread"