The drop in expected S&P earnings is in the sweet spot for big stock-market gains over the next 12 months

CHAPEL HILL, N.C. – It’s good news that the S&P 500’s earnings per share in the fourth quarter will likely be significantly lower than in the fourth quarter of last year.

With the exception of when this rate of change is less than minus 20%, there is an inverse relationship between earnings growth rates and the market’s average return. By the time earnings growth rates are extremely high—as they were late last year and early this—they have long since been reflected in stock prices. During such periods, the market has instead shifted its focus to earnings several quarters hence—to factors such as the Federal Reserve having to put the brakes on an overheating economy.

A spectacular recent example came during the 2008 financial crisis. The S&P 500’s year-over-year growth rate in trailing four-quarter earnings was minus 19% in the fourth quarter of 2007, a rate that historically has been associated with a rising stock market. But earnings continued falling through 2008; by the fourth quarter of that year, the growth rate was minus 78%.

MktwHulbert “BeCaUsE FeD PiVoT.”

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