MarketWatch - Good news: Earnings growth is slowing

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"Good news: Earnings growth is slowing

Commentary: A contrarian — and surprising — take on earnings

By Mark Hulbert , MarketWatch

Last Update: 12:01 AM ET Aug 7, 2012

CHAPEL HILL, N.C. (MarketWatch) — Worried that lower earnings growth will lead to a bear market?

You’re not alone. Almost everyone else is concerned too.

But, by following the herd, you run the distinct possibility of becoming too worried: The stock market historically has performed better when earnings growth is slower than when it is faster.

That at least is the conclusion reached by a study conducted by Ned Davis Research, the quantitative research firm. After analyzing year-over-year earnings growth back to 1927, the firm found that the stock market tends to underperform whenever earnings growth is particularly strong.

The reason for this counterintuitive finding, according to Ed Clissold and Dan Sanborn, U.S. market strategists for Ned Davis Research and co-authors of the study: The market senses that high earnings growth is unsustainable, and is therefore discounting an imminent “slower earnings-growth environment.”

Take a look at the accompanying chart. The Ned Davis analysts found that the stock market historically has performed the best during periods in which year-over-year changes in quarterly earnings were either flat or falling modestly: When quarterly earnings growth was less than 5% and not worse than minus 20%, the S&P 500 index (SPX) grew at an annualized average of 12.4%.

This compares to an average annualized return of just 2.4% whenever earnings growth was above 20% and 6.4% when that growth rate was between 5% and 20%.

What does this all mean for the current market?

Earnings per share for the S&P 500 for the quarter we’re in right now are estimated by Standard & Poor’s to be $25.18 on an “operating earnings” basis, and $24.18 on an “as-reported” basis. That’s 0.4% lower and 6.8% higher, respectively, than the comparable totals for the year-ago quarter.

As Clissold and Sanborn put it, these “consensus estimates call for earnings growth to oscillate between the two middle — and most bullish — zones” of the accompanying chart.

Another, perhaps equally counterintuitive implication of the Ned Davis study: If indeed earnings growth slows as expected, growth stocks are likely to outperform value stocks. I found this surprising, since value stocks are less overvalued than growth stocks.

But Clissold and Sanborn explain: “In a slow-growth environment, a premium is placed on companies that continue to deliver top-line and bottom-line growth. Almost by definition, those are growth stocks.”

The bottom line? Once again, it pays to at least consider a contrarian perspective. Without it, you’d risk becoming far more gloomy and pessimistic than the historical data actually suggest is justified."