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Some exuberant analysts are trying to put a bullish spin on the dramatic slowing in the S&P 500’s earnings per share growth rate projected for the next several quarters. They are wrong .
The table below summarizes the S&P 500’s
SPX,
trailing 12-month as-reported EPS growth rates, based on estimates from Standard & Poor’s. Notice that the year-over-year growth rate at the end of 2022 is projected to be about one-eighth of what it was in this year’s third quarter. Moreover, earnings projections typically are overly optimistic.
| Quarter ending | Year-over-year change in trailing 12-month EPS |
| Sep. 30, 2021 | 84% |
| Dec. 31, 2021 | 47% |
| Mar. 31, 2022 | 23% |
| Jun. 30, 2022 | 24% |
| Sep. 30, 2022 | 16% |
| Dec. 31, 2022 | 10% |
Since 1927, as many on social media have been pointing out, the S&P 500 has turned in its best returns, on average, during quarters in which the year-over-year change in EPS was negative — between 25% lower and 10% lower, in fact. The S&P 500’s annualized return during such quarters was 26.7%, according to Ned Davis Research, versus an average gain of 2.4% during quarters in which the S&P 500’s year-over-year rate over change was greater than 20%.
The problem with this narrative isn’t with the underlying data, which (like all of the data supplied by Ned Davis Research) is top-notch. The problem instead is with the interpretation the bulls are putting on the data.
That’s because the Ned Davis data reflect a contemporaneous relationship, correlating the stock market’s performance in a given quarter with EPS growth rate over the 12 months up to and including that same quarter. But since the stock market is forward looking, its performance in a given quarter will to a far greater extent reflect projected earnings growth several quarters hence.
To show how forward looking the stock market typically is, I calculated the correlation coefficient between the S&P 500’s return in a given quarter and earnings growth rates in subsequent quarters. As you can see, the strongest correlation exists with the growth rate three-quarters hence. (My calculations reflect the market back to 1871, courtesy of data from Yale University’s Robert Shiller.)
| Correlation coefficient between S&P 500’s growth rate in given quarter and EPS y-o-y growth rate in specified quarter | |
| Same quarter | 1% |
| 1 quarter hence | 7% |
| 2 quarters hence | 14% |
| 3 quarters hence | 17% |
| 4 quarters hence | 10% |
When focusing on the correlation with the earnings growth rate three quarters hence, the bulls’ “less is more” story disappears. For example, when the year-over-year EPS growth rate three quarters hence is between negative 10% and negative 25%, the S&P 500’s average quarterly return is 8.2% annualized. When that growth rate is over 20%, the S&P 500’s average return is almost double — 14.8% annualized.
In other words, when measured properly, faster earnings growth correlates with higher stock market returns — just as you’d expect.
Why market forecasting is so difficult
The correlation coefficients in the above table are relatively low. Even though the 17% coefficient that exists when focusing on three-quarters hence is statistically significant, it won’t help you much to beat the market. This coefficient means that subsequent earnings growth explains or predicts only a small portion of the stock market’s return.
I devoted a column to this subject this past March, and interested readers should consult it for a fuller analysis. In short, I reported that you would have significantly lagged a buy-and-hold strategy since 1980 even if you were clairvoyant enough to know the earnings growth rate 12 months into the future. That’s because changes in the price/earnings ratio have had a greater impact on the stock market’s shorter-term return than the earnings themselves.
The bottom line? While there is something intuitively appealing about the bulls’ narrative about less being more, it’s unhelpful and may be flatly wrong.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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