CHAPEL HILL, NC — It’s good news that earnings per share for the S&P 500 in the fourth quarter will likely be significantly lower than in the fourth quarter of last year.
At first glance, this doesn’t seem like something to celebrate. Yet, except when corporate earnings plummet, the stock market actually tends to do better when EPS growth rates are negative than when they are overwhelmingly positive.
The relevant data (courtesy of Ned Davis Research) is plotted in this graph. Note that the highest annualized return in the market over the past century – 25% – was produced when the SPX of the S&P 500,
the year-over-year change in four-quarter EPS is in the range of 20% lower to just 5% higher.
Except where this rate of change is less than minus 20%, there is an inverse relationship between earnings growth rates and the average market return.
Why this historical pattern is potentially good news for the current DJIA stock market,
is that the fourth quarter EPS growth rate should be exactly in the cohort associated with the highest average annualized return, as you can see in the chart below. (Note that growth rates for the third and fourth quarters are based in part on consensus analyst estimates.)
| Trimester | Year-over-year growth rate of S&P 500 EPS over the last four quarters |
|
Fourth quarter 2022 |
-5.2% |
|
Third quarter 2022 |
+8.9% |
|
Second quarter 2022 |
+21.1% |
|
First quarter 2022 |
+54.4% |
Refresh the future
The source of this otherwise surprising inverse relationship between the market and earnings growth rates is the stock market’s focus on several quarters into the future.
At a time when earnings growth rates are extremely high – as they were at the end of last year and at the start of this one – they have long since been reflected in stock prices. During these periods, the market was instead focused on earnings in several quarters, on factors such as the Federal Reserve having to rein in an overheating economy.
The reverse is usually what happens when the year-over-year growth rate of EPS over the last four quarters turns negative. Instead of focusing on that, which will have long since discounted into the market level, investors will have shifted their attention to the likely impending rebound in earnings.
The exception to this general trend occurs when EPS growth rates drop like a rock and therefore do not recover quickly after falling into slightly negative territory.
A dramatic recent example came during the 2008 financial crisis. The S&P 500’s year-over-year earnings growth rate for the past four quarters was minus 19% in the fourth quarter of 2007, a rate that has always been associated with a rise in the stock market. But profits continued to fall until 2008; in the fourth quarter of that year, the growth rate was minus 78%.
That seems unlikely this time around, at least according to S&P Global’s analyst consensus projections. The year-over-year growth rate of EPS over the last four quarters is expected to increase gradually throughout 2023 and reach 13% in the fourth quarter of next year.
Unless those projections are not just a little off, but off base, and instead you’re anticipating a repeat of something like the Great Financial Crisis of 2008, history suggests that the current earnings slump is not no reason to sell everything and go cash.
Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be contacted at [email protected].
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