Psychic Stocks That Foresaw a Profit Crash Are Much Happier Now

(Bloomberg) -- This time 12 months ago, the bull market was approaching extinction. While it lived to see another day, what followed was a year of near-zero profit growth.

Unrelated facts? Unlikely. One of the best explanations for the $5 trillion equity meltdown that culminated at Christmas is that it represented investors figuring out a poor year for corporate earnings was in the cards, and adjusting prices accordingly.

It’s an old adage. Markets see the future first.

What about now, when investors are enjoying the opposite of last year’s rout? The S&P 500 has jumped 10% since October began, gaining in 10 of the last 11 weeks. If you believe share prices are prescient, it may bode well for 2020’s economic tidings.

“The market’s always been a forward-pricing mechanism,” said Art Hogan, chief market strategist at National Securities Corp. “What’s the market getting right or wrong? The market is trying now, in the last three months, to price in what might go right in 2020.”

What could go right is a rebound in growth, a pick-up in S&P 500 profits. At the close of a year in which the yield curve inverted, recession bells rang and a trade war weighed on executive confidence, the index is notching one of its best rallies in decades. Meanwhile, earnings growth has been virtually non-existent, but the future is looking brighter.

An October study by the research firm CXO Advisory Group LLC looked at the relationship between earnings and market moves and found that stocks usually anticipate corporate results, not the other way around. The “strongest indication” observed in the study was that stock returns lead earnings by one quarter.

The connection may have been at work last year, when the worst fourth quarter of the bull market preceded a raft of earnings downgrades. Expectations for 10% profit growth were dashed, and projections tracked by Bloomberg Intelligence fell by the most since 2016, when S&P 500 firms were in the midst of an earnings recession.

A similar prescience was on display in 2017, too. The S&P 500 jumped 6% in the fourth quarter, topping off a 20% gain, in anticipation of the Trump administration’s corporate tax overhaul. In the three months that followed, forecast profit growth for 2018 surged near seven percentage points, and by the end of 2018, S&P 500 companies had seen three separate quarters in which earnings grew more than 20%.

Strategists at Ned Davis Research also studied the stock-profit connection and came up with similar -- if not identical -- conclusions. Their data found equity prices often move inversely to earnings in real time. That is, strong earnings growth is often met with indifferent stock performance, a sign investors are more interested in quarters to come. In years when profits have jumped more than 20%, the S&P 500 has risen 2.4% on average, the firm found. Meanwhile, when growth has been below 5%, the benchmark has gained 12.2%.

This year and last year have fit the model. Double-digit profit growth in 2018 was met with some of the worst stock returns this decade, and stagnant earnings this year have garnered some of the best.

It’s rare, though not unheard of, for the economy to tank right after a rally as big as this. Since 1930, there have been 17 calendar years in which the S&P 500 gained 25% or more. A recession followed only three times -- in 1990, 1981 and 1937. Recessions and big rallies are both probably too rare to generalize much about their connection, but usually the market isn’t this buoyant just before a downturn.

According to Bank of America Corp., any upside for U.S. stocks next year will need to be driven by rising profits. To get to the firm’s year-end S&P 500 target of 3,300, earnings growth will have to do the heavy lifting, since years of extreme multiple expansion are typically followed by years of “flattish to contracting multiples,” said strategists including Savita Subramanian.

While Wall Street equity strategists are predicting somewhat more modest profit gains next year, bottoms-up analyst forecasts still call for a near 10% jump. It’s typical, though, that estimates get tempered as a time period draws closer, and a measured drop in EPS projections shouldn’t catch the market off guard, strategists say.

Mike Bailey, the director of research at FBB Capital Partners in Maryland, calls the phenomenon “the worst kept secret.”

“If investors already know that, there’s not going to be some panic when you wake up July 1, saying ‘Oh my gosh, the Street numbers are only growing 5% not 10%. Panic!’ ’’ Bailey said by phone. “Investors are going to say, ‘We knew that was going to happen.’ If you go from crummy growth this year to reasonable growth next year, that does support valuations.”

Those expectations may be baked into stock prices already, but some investors worry the market may not be as efficient as it proved years ago. David Spika, the president of GuideStone Capital Management, says the proliferation of passive, systematic, and quantitative strategies has diluted the market’s foresight. Alex Pire, head of client portfolio management for Seeyond, a subsidiary of Natixis Investment Managers, has a similar concern.

“That’s what the stock market is supposed to be -- it’s a discounting mechanism,” Pire said in an interview at Bloomberg’s New York headquarters. But “it is taking longer than it used to. Potentially what that means is we could get into a situation where the market continues to rise, yet we’re seeing the rest of the economy actually doing very poorly, and then you have a much broader cliff that happens.”

To contact the reporters on this story: Sarah Ponczek in New York at sponczek2@bloomberg.net;Vildana Hajric in New York at vhajric1@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Chris Nagi, Richard Richtmyer

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