The drop in expected S&P earnings is in place for significant stock market gains over the next 12 months

Chapel Hill, North Carolina – It’s good news that earnings per share for the S&P 500 in the fourth quarter are likely to be significantly lower than they were in the fourth quarter of last year.

On the surface, this doesn’t seem like something to celebrate. However, except when corporate earnings are falling off the bed, the stock market actually tends to perform better when EPS growth rates are negative than when it is overwhelmingly positive.

Related data (supplied by Ned Davis Research) is shown in this chart. Note that the highest annual market return over the past century – 25% – was produced when the S&P 500’s SPX,
+2.41%
The year-over-year change in earnings per share for the four quarters was in a range from 20% lower to only 5% higher.

Except when this rate of change is less than negative 20%, there is an inverse relationship between earnings growth rates and average market return.

The reason why this historical pattern is potentially good news for the DJIA stock market today is,
+ 2.51%
is that fourth-quarter EPS growth is expected to fall squarely within the group associated with the highest average annual return – as you can see from the table below. (Note that growth rates for the third and fourth quarters are based in part on the consensus of analyst estimates.)

a fourth

Annual growth rate in the last four quarters of the Standard & Poor’s 500 EPS

Fourth Quarter 2022

-5.2%

Third Quarter 2022

+ 8.9%

Q2 2022

+ 21.1%

First Quarter 2022

+ 54.4%

future discount

The source of this surprising inverse relationship between the market and earnings growth rates is the stock market’s focus several quarters into the future.

By the time earnings growth rates are so high — as they were late last year and early this year — they have long been reflected in stock prices. During these periods, the market shifted its focus instead to earnings several quarters, and thus to factors such as the Federal Reserve having to rein in an overheating economy.

The reverse is usually the case when the fourth-quarter annualized growth rate of EPS turns negative. Instead of focusing on that, which would have long ago discounted the market level, investors would have shifted their focus to the potential impending rebound in profits.

The exception to this general pattern occurs when EPS growth rates decline like a rock, and therefore do not return quickly again after falling into modest negative territory.

A striking recent example came during the 2008 financial crisis. The annual growth rate of the S&P 500 in earnings for the subsequent four quarters was minus 19% in the fourth quarter of 2007, a rate that has historically been associated with a stock market rally. But profits continued to decline during 2008; By the fourth quarter of that year, the growth rate was negative 78%.

That seems unlikely this time around, at least according to S&P Global’s forecasts of analyst consensus. The annual growth rate of delayed earnings per share is expected to increase by four quarters gradually throughout 2023, and by the fourth quarter of next year, to 13%.

Unless these forecasts are slightly wrong but far from the norm, and instead expect a repeat of something like the Great Financial Crisis of 2008, history suggests that the current earnings slump is no reason to sell everything and cash in.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert rating tracks investment newsletters that pay a flat fee to review. He can be reached at mark@hulbertratings.com.

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