Rates usually trump earnings growth

[HenryTo]

Great article from Mark Hulbert on what we can expect from the stock market this year. Summary: Not good and possibly bad is all I can say.
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Rates usually trump earnings growth

By Mark Hulbert, MarketWatch
Last Update: 12:01 AM ET May 3, 2005

ANNANDALE, Va. (MarketWatch) -- Fed Chairman Alan Greenspan is responsible for making the word "conundrum" part of investors' vernacular.

He was referring, of course, to his inability to explain why the spread between short- and long-term interest rates has narrowed over the past year. (Read archived story.)

But the conundrum that has many investors and advisers stumped these days is different: Why, if corporate earnings are growing as strongly as they appear to be, is the stock market behaving so sluggishly?

Consider how fast earnings are growing: According to the latest projection from Thomson Financial, based on reports from most but not all companies, first quarter earnings for the S&P 500 (SPX: news, chart, profile) will be 13.6% higher than what they were reported to be in the first quarter of 2004. (Read full story.)

As recently as a week ago, Thomson was projecting a 12.1% increase. And at the beginning of the year, the firm was expecting the growth rate to be 7.6%.

This upward revision is important to keep in mind as we interpret what is projected for the current quarter. Thomson currently is projecting that second quarter earnings for S&P 500 companies will be 7.2% higher than comparable quarterly earnings from 2004. This is higher than the 7.1% that the firm was projecting a week ago, despite the above-average number of negative pre-announcements.

Notice also that the current projection of 7.2% is only slightly below the projection that stood at the beginning of the first quarter. Given that the current regulatory environment gives incentives to companies to be conservative when projecting earnings, the final number could very well turn out to be higher.

So the earnings picture is not all that bad.

Why, then, is the market not performing better?

Unlike Greenspan's conundrum, however, for this one researchers have an explanation: Faster earnings growth puts more pressure on the Federal Reserve to raise interest rates. And in a head-to-head contest over which factor has greater impact on the stock market, interest rates usually trump earnings growth.



Consider data compiled by Ned Davis Research. Over the past 80 years, faster earnings growth has reliably been accompanied by a more sluggish market - except when earnings were falling out of bed and were more than 25% below year-earlier levels.

The 13.6% earnings growth rate that Thomson Financial is now projecting for the first quarter falls in the middle of a category associated with an average S&P 500 gain of 5.8% annualized - about half the market's long-term historical growth rate. Because there is a wide range in the actual returns of the quarters that fall into this category, however, the S&P 500's actual return during 2005's first quarter - minus 2.6% -- is well within the confines of the historical record.

The projected market return for the current quarter would be only slightly higher if Thomson's projection for the second quarter -- 7.2% growth -- is accurate. The category into which this would fall is associated with an average annualized return since 1924 of 9.4%, which is still below the market's long-term average.

Another way of understanding the finding from Ned Davis Research is to think of the roles that earnings growth and interest rates play throughout the economic cycle.

When the economy is just emerging from a recession, quarterly earnings often will be well below those of a year earlier. But the stock market, as a discounting mechanism, senses that earnings are about to start growing again. Even better, there will be no pressure on the Fed to raise interest rates, since the economy is only emerging from a recession.

This combination of imminent earnings growth and no interest rate pressure proves to be a powerful tonic for the market. This explains why, according to Ned Davis Research, the highest average stock market returns since 1924 were registered in quarters in which quarterly earnings were between 10% and 25% below year-earlier levels. During all such quarters over the last 80 years, the S&P 500 produced an average annualized gain of more than 28%.

Unfortunately, from the point of view of where we stand in the economic cycle today, conditions currently are not conducive to producing gains anywhere near this explosive. And they won't be again until we emerge from the next economic recession.

That doesn't mean that the market must go down. After all, the historical record suggests that we should see a modest gain.

But this analysis does suggest that we are fooling ourselves if we expect explosive profits from stock the market this year.