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 user 2005-02-07 at 9:44:00 am Views: 86
  • #10093

    If Profits Grow, How Can the Market Sink?

    THE faster corporate earnings grow, the better the stock market
    performs. That is a tenet of Wall Street, but like so much other conventional
    wisdom, it turns out to be false.

    In fact, 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.

    Of course, these findings for the overall market run counter to
    the experience of specific companies. For many of them, the relationship of
    earnings growth and stock price is often positive – especially when a company
    exceeds profit expectations.

    But according to a recent study, it makes sound economic sense
    that what sometimes prevails for one company does not apply to the overall
    market. The study, “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.

    The reason that the overall market usually fails to react more
    favorably to rapidly rising earnings is not that earnings growth is bearish
    itself. The problem, the professors say, is that such 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.

    The professors say the Federal Reserve is unlikely to feel
    pressure to raise rates when just one company reports better-than-expected
    earnings. So the company’s profit growth can be expected to translate into a
    higher stock price. But the Fed will certainly feel that pressure when aggregate
    market earnings rise quickly.

    To be sure, the professors’ findings are based on a long-term
    average, and exceptions are inevitable. One occurred in the last couple of
    years, when earnings grew at a double-digit rate and the overall market
    performed well, too. But Professor Lewellen says that this recent experience is
    “the exception that proves the rule,” because the Fed kept interest rates
    artificially low over much of this period. That prevented the fast growth of
    marketwide earnings from having usual negative consequences.

    The powerful role of interest rates in the stock market’s
    valuation also explains why the market tends to perform best when aggregate
    corporate earnings are falling. Ned Davis Research says 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

    This bullish effect vanishes, however, when earnings are falling
    too much. Ned Davis Research found that during those few quarters since 1927
    when earnings were more than 25 percent below their year-earlier levels, the
    S.& P. 500 declined at a rate of 28 percent, annualized. Professor Lewellen
    says that this is consistent with the results of his research. “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.”

    An implication of the professors’ study is that the market’s
    performance is likely to be below average this year, because of the consensus
    expectation for double-digit profit growth accompanied by rising interest rates.
    S.& P. estimates that per-share operating earnings of the S.& P. 500
    companies in the first quarter will be 14 percent higher than in the
    year-earlier period. Earnings for all of 2005 are projected to grow 12 percent.
    In quarters since 1927 when profit growth has been in the neighborhood of what
    S.& P. is projecting this year, according to Ned Davis Research, the S.&
    P. 500 has appreciated at an annualized pace of 5.8 percent. That is about half
    the market’s long-term average rate.

    The pattern discerned by the professors could create buying
    opportunities down the road. That is because investors tend to drive market
    valuations way down when interest rates rise over a sustained period. A
    diversified stock portfolio bought at a time of depressed valuations can be
    expected to appreciate when interest rates fall. But if the pattern holds this
    time, it’s way too early for the market to start going much higher.