Earnings growth is falling. What this means for the stock market

by Troy

The S&P 500 is now back above its 200 day moving average.

Let’s determine the stock market’s most probable direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

*Probability ≠ certainty.

Earnings growth is falling

The S&P 500’s earnings growth is going to fall in Q4 2018, and will fall much more next year (as of Q1 2019).

You can expect mainstream financial media to scream “EARNINGS GROWTH IS FALLING! BEARISH!!!”

I disagree.

The stock market doesn’t care about whether earnings growth is rising or falling. The stock market cares about whether earnings are rising or falling.

In other words, focus on the first derivative for corporate earnings (growing or decreasing) instead of the second derivative for corporate earnings (rate of growth increasing or decreasing).

The following chart demonstrates the year-over-year change in earnings growth. What do you notice?

The year-over-year change in earnings growth has almost no correlation with the stock market’s performance, unless earnings growth goes below zero.

Right now, Wall Street analysts expect earnings growth to fall to 5-6% by 2019. This is because they expect profit margins to remain flat, which means that earnings will grow at the same % as sales in 2019 (i.e. 5% a year).

So the conclusion is simple. “Peak earnings growth” is not bearish for stocks. Falling earnings growth is not bearish for stocks, UNLESS earnings growth turns negative.

At this rate, such an event is unlikely to happen until the second half of 2019.

What the bond market is telling us about the stock market

Last week the bond market went up (interest rates fell) while the stock market rallied significantly.

According to one prominent permabear on twitter (who shall remain unnamed), this is long term bearish for the stock market, because “the past 3 events all occurred during bear markets” (2000, 2001, and 2008).

Looking at the data selectively to suite one’s bias is not a good idea.

Let’s look at the data and facts holistically.

Here’s what happened next to the S&P 500 when it goes up more than 4.5% in the past week, while the 10 year yield falls.

*Data from 1962 – present

As you can see, this is not consistently bearish for the stock market on any time frame, especially 6-9 months later.

Let’s narrow down the sample size, and look at the cases in which the S&P was above its 50 week moving average (i.e. right now). After all, context is important. There’s a difference between an event that happens while the stock market is high vs. an event that happens while the stock market has already crashed 30-40%.

Once again, we can see that this isn’t consistently bearish for the stock market on any time frame.

Yield curve inversion

As I said last week, the yield curve is starting to invert. The 5 year – 3 year yield curve inverted today.

The 5 year – 2 year yield curve will probably invert over the next few days.

Once again, here’s what happens next to the S&P when the 5 year – 2 year yield curve inverts.

The sample size is small, but this serves to illustrate that the yield curve tends to invert BEFORE a bull market tops.

Large gap up

Today’s “gap up” on the OPEN was quite big: >1%

Here’s what happened next to the S&P 500 when it gapped up more than 1% on the OPEN.

*Data from 1962 – present

As you can see, the stock market tends to do well 6 months – 1.5 years later.

What’s uncommon is for the stock market to gap up this much while it is above its 200 day moving average. Most large caps occur when the stock market is down e.g. -20% to -40%, because the stock market’s daily volatility is higher in such times.

Let’s isolate for the cases in which the S&P is above its 200 day moving average after the big “gap up”

You can see that the optimal returns occur 6-9 months later.

MACD

The stock market’s 12, 24, 26 MACD will potentially roll over. In the past 20 years, this has been a sign of trouble for the stock market.

So how bearish is this for the stock market?

Let’s look at the data holistically.

Here’s what happened next to the S&P 500 when its monthly MACD (12, 24, 26) histogram crosses below zero.

Conclusion: this is not consistently bearish for the stock market.

XLV

XLV (healthcare sector) has been much stronger than the rest of the stock market this year.

It is now within 1% of a 1 year high, while the S&P 500 is still more than -4% below its 1 year high.

Here’s what happened next to the S& 500 when XLV was within 1% of a 1 year high, while the S&P 500 is more than -4% below a 1 year high.

*Data from 1999 – present

Now let’s narrow down the cases to which the S&P is above its 200 day moving average.

On the surface, this study seems bullish. I wouldn’t put too much weighting into this study. I generally don’t like to use individual stocks or individual sectors to predict the entire stock market.

Click here to see yesterday’s market study

Conclusion

Our discretionary technical outlook remains the same:

  1. The current bull market will peak sometime in Q2 2019. Then a bear market will ensue. We are in a long term topping process. Tops are a process, not an event.
  2. The medium term remains bullish (i.e. approximately next half year).
  3. The short-medium term is mostly a 50-50 bet.

We focus on the medium term and long term. We mostly ignore the short term, which is usually just noise.

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