Posts filed under “Markets”
I’ve been having an interesting discussion with my friend Tony Dwyer of FT Finacial over the impact of year-over-year changes in S&P500 earnings on subsequent market performance. TD is a savvy market technician whose charting work is both straightforward and yet different enough from the mainstream as to be value added and worthwhile.
click for larger graph
"Since 1927, according to data from Ned Davis Research of Atlanta, the market has performed best during quarters when earnings are as much as 25 percent below year-earlier levels. When earnings are growing strongly, as many expect them to do this year, the market has tended to have below-average performance."
A recent study confirms this: "Stock Returns, Aggregate Earnings Surprises, and Behavioral Finance," by S. P. Kothari, an accounting professor at the Massachusetts Institute of Technology; Jonathan W. Lewellen, an M.I.T. finance professor; and Jerold B. Warner, a finance professor at the University of Rochester, has been circulating as an academic paper since last year.
I actually disagree (in part) with the explanation why the overall market "fails to react more favorably to rapidly rising earnings." The profs argue that earnings growth itself is not bearish, but rather the problem, is that "growth usually leads to higher interest rates. When rates rise, the net present value of future earnings, cash flow and dividends automatically falls, and this generally causes the market to decline."
I see a behavioral explanation rather than an interest rate when – but they are two sides of the same coin. To me, when earnings are plummetting, its because the economy is in or about to enter a recession. Stocks have likely already had a big run up in the pre-recession period. So stocks get dumped in this period. Think 1991 or 2002.
The Profs focused on the powerful role of interest rates, as it relates to stock market’s valuation. They wrote that Market tends to perform best when aggregate corporate earnings are falling — which typically occurs when rates drop like stones. Again, consider what the sentiment is like during these periods.
Ned Davis Research determined that "since 1927, the Standard & Poor’s 500-stock index has risen at a 28 percent annualized rate – nearly triple its historical average – during quarters in which earnings were 10 to 25 percent lower than where they were in the periods a year earlier."
Lastly, NDR noted that the bullish effect vanishes, when earnings are falling too much. That’s typically because the economy is in the earlier stages of a longer contraction. During those quarters when earnings were more than 25 percent below their year-earlier levels, the S.& P. 500 declined at a rate of 28 percent, annualized (since 1927).
The academics explained it thusly: "The positive effects of lower interest rates, though strong enough to overcome the negative consequences of more modest declines," he said, "are unable to overcome them when earnings are falling by a huge amount."
Kinda like 2000?
The key to this lies with psychology: Perception versus reality. When year-over-year earnings improve from awful to merely bad, the headlines are still extremely negative. But this is the earliest partof the recovery, and no one — at least, almost no one — has recognized the changing character of the economic cycle. Hence, event though the mood is palpably morose, that’s when you gotta buy ‘em: Not only when everyone hates ‘em, but when we see quantititative proof of the cycle turning.
Admittedly, this is easier said than done.
If Profits Grow, How Can the Market Sink?
NYT, February 6, 2005
Joe Granville is a
very well regarded technician (now in his 80s) who has had some terrific calls in his career, and a few duds as well. On Bloomberg, there was a story on his most recent commentary, but I cannot seem to find it now; It more likely got moved than disappeared for nefarious reasons.
Anyway, Joe just got Bearish big time. Here’s an excerpt:
"Joseph Granville, who accurately forecast in 2000 that U.S. stocks’ bull market would end, is at it again. He expects the Dow Jones Industrial Average to suffer its biggest annual loss this year since the Great Depression.
“We’re in the critical portion of a coming collapse and the market’s screaming to get out,” said Granville in an interview from Kansas City, Missouri. “Everyone’s bullish. There’s going to be a tremendous surprise and it’s going to be to the downside.”
"Granville, publisher of the Granville Market Letter since 1963 and a technical analyst for almost 50 years, also foretold a stock-market decline in 1976. He misfired in 1982 and 1995 by calling for losses before share prices surged.
The 81-year-old analyst expects the Dow average to retreat to at least 7400 by year-end. The forecast amounts to a plunge of 31 percent. The last year in which the benchmark fell that much was 1937, when it lost 33 percent.
As a technical analyst, Granville predicts the market’s direction by using criteria such as trading and price patterns, rather than earnings and economic growth. He started developing his stock market theory at what was then E.F. Hutton & Co., a New York-based brokerage, from 1957 to 1963."
That bodes well for my 2005 forecast, as Joe tends to be early. I’m still looking for one last strong move up — Dow 11,700, Nasdaq 2600 — before it all heads south. Note that also gives me the opportunity to stay long if the uptrend remains in tact.
One of the key mistakes to avoid – call it the peril of predictions — is to never marry a forecast, especially your own. People wrap up too much ego in what is essentially educated guesswork. If you start with the assumption that your prediction is going to be wrong, its real easy to reverse yourself when necessary . . .
If you are interested in learning more about Granville,start with this article — Just Like Old Times as Joe Granville Yells `Sell’ — it gives some background on him if you are unfamiliar with his work.
Some more background on Granville:
Timing the Market
Joe Granville, father of the On Balance Volume (OBV) and its analysis
Bibliography of Published Books
UPDATE: March 18, 2005 7:09 am
Mark Hulbert provides the details on Granville’s track record. Not impressive (unless you are a fan of the Black Swan event . . .)
UPDATE: I still cannot find this anywhere, but a friend captured the text. Here it is for your enjoyment: