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The Speculator
Why earnings optimism is bad
news
Forget everything you've heard. When S&P 500 earnings
rise, stocks are getting ready to fall. And when earnings sink,
stocks outperform.
By Victor
Niederhoffer and Laurel Kenner
Everything you think you know about the relation
of earnings and the stock market is wrong.
How
many of the millions of market stories tell you that stocks are up
on earnings optimism, or down on earnings woes? Most, right? Forget
those stories -- they’re based on a fallacy.
We analyzed
earnings and market data going back to 1937. We discovered that if
earnings rise in a quarter, the S&P 500 ($INX)
is likely to underperform the average 9% annual upward drift
of the market in the next quarter. And if earnings fall in a
quarter, the S&P 500 is likely to outperform that average
in the next quarter.
The conventional wisdom on earnings, it
seems, is just one more weapon in the market’s splendid arsenal of
ways to relieve the investor of his chips. What everyone knows about
individual stocks -- that strength in price tends to follow strength
in earnings -- turns out to be wrong when data for the market is
aggregated.
What you can do
now
Whenever we come up with a finding like this, our
editors always want to know how readers can use it right away to
make money. They remonstrate that if we don’t say what to buy or
sell, we won’t get many readers and our stuff will be buried by
something more timely.
As it turns out, our studies do
suggest a highly useful course of action. Using the 65 years of
data, during which the trend of quarterly S&P 500 returns was
2.5%, we found a way to arrive at a rough prediction of S&P 500
index returns based on earnings changes for its combined
components.
| Combined quarterly earnings per share,
S&P 500 |
| Quarter |
2000 |
2001 |
| 1 |
$12.1 |
$12.0 |
| 2 |
12.4 |
10.6 |
| 3 |
12.5 |
7.6 |
| 4 |
13.0 |
5.9 | | Source:
Standard & Poor’s Security Price Index Record
To
calculate the expected change in the S&P index from fourth
quarter 2001 to first quarter 2002, for example, our formula would
be:
The expected change = 2.5% - (1/20 x change in S&P
earnings Q4 2001 over Q4 2000). In other words, the expected change
would be 2.5%-(.05 x -55%) = 5.25%.
That’s highly bullish,
and completely opposite from the Delphic pronouncements, untested
suppositions and rote journalistic catch phrases that the average
investor is likely to be swayed by.
But the market loves it
when investors, seeking only to understand what’s going to affect
their wealth, are pulled in the wrong direction. That way, investors
can contribute to the tremendous frictional upkeep required to pay
the market’s bills -- which is to say, Manhattan high-rises, broker
salaries and marketing.
Not content to put our pencil and
paper away without thoroughly exploring the earnings-market
shibboleth, we also looked at the relation on an annual basis. We
found similar relations prevailing:
- If S&P 500 earnings rise in a year, the S&P 500 is
likely to perform worse than average that year.
- And if earnings fall in a year, the S&P 500 is
likely to perform better than average that
year.
Reading the
future
The objection may be raised that we have failed to
consider the question of earnings disappointments, or changes in
analysts’ earnings projections, or to compare the top-down
predictions of the white-shoe strategists with the bottom-up
estimates of the spoon-fed analysts. Some might complain that we
have no black box to which we feed data from the last business
cycle. Some sophisticated readers may even darkly hint that we have
failed to consider the tens of thousands of academic articles that
have tried to wrestle with these questions.
Truth to tell,
even the Spec Duo -- energized as we are by the vituperation heaped
on our heads by our call for a long stock market-short REIT trade --
would find reviewing the bulk of all this admirable knowledge a mite
taxing. In fact, we have calculated that it would take us two
lifetimes to read the academic literature alone.
However, we
did read hundreds of articles. The problem with many of them is that
they didn’t use recent data, and the formulas arrived at were
descriptive rather than predictive.
Strangely, the insights
we found most useful came from one of our homespun readers, the
sharp Tennessee philosopher Jack Tierney. Tierney says he believes
that the relation between earnings and prices has changed recently
as we have come to focus more on estimated future earnings and less
on absolute earnings. Any increase in forecasted earnings justified
upward valuation, regardless of current value or P/E.
But
the piper had to be paid. As past earnings became difficult to
match, expectations were recalibrated. Investors focused on whether
companies made the new, lower forecasts, disregarding how much the
bar had been lowered. “A company which exceeded its internally
manufactured estimates, no matter how questionable the calculation,
was doing well and could expect a pop,” Tierney wrote. “In my view,
this indicates a significant disconnect between investor perception
of profits and price.”
For our new readers, the best way to
verify our assertions is to actually count them out. We will send
all who write gbuch@bloomberg.net a scatter
chart of the numbers with S&P 500 earnings and returns from 1937
to the present. (We believe that 65 years was enough to test the
hypothesis.)
We ran our conclusions by one of our readers,
Bill Egan, a U.S. Army Reserve captain who earned his Ph.D. in
chemometrics, a rare combination of analytical chemistry and applied
statistics. Not only that, he is married to a psychometrician. The
Egans ran some calculations of their own on independent data sets
from Pinnacle Data that verified our conclusions. Using weekly data
from 1962 to 1994, the Egans found that the return in the S&P
500 is quite good at predicting future earnings, but that earnings
moves themselves are correlated quite negatively with future S&P
500 changes.
As a start for those who might wish to explore
new ideas, let us encourage you to examine the data for yourself and
see if you should be happier when the airwaves, computer monitors
and newsprint are full of earnings optimism or earnings pessimism.
End notes
Biotech
update: We try in our columns to provide a mix of meal for a day
and meal for a lifetime. Regrettably, what we do best -- predicting
very short-term swings in the market -- has too short a shelf life
to be of use to readers, given the time lapse between writing and
publication. Nevertheless, we have been investing our own money in
our ideas on individual stocks.
Late last year, we began
buying biotech stocks under an insider buy signal system that
yielded retrospective returns of 50% a year over a five-year period.
The first group went up 25% in a month, and we recommended their
sale. Some months later, we recommended a hedged portfolio of
biotechs. A few weeks ago, with S&P 500 futures down in the
1,070 area, we doubled up. We routinely adjust the portfolio by
selling when insider sales eclipse insider buys, and purchasing
stocks that insiders have been buying. The current portfolio is as
follows.
Avant Immunotherapeutics (AVAN,
news,
msgs)
Cima
Labs (CIMA,
news,
msgs)
Columbia
Laboratories (COB,
news,
msgs)
Cooper
Cos. (COO,
news,
msgs)
Cyberonics (CYBX,
news,
msgs)
DOR
BioPharma (DOR,
news,
msgs)
Eclypsys (ECLP,
news,
msgs)
Guilford
Pharmaceuticals (GLFD,
news,
msgs)
Genelabs
Technologies (GNLB,
news,
msgs)
Inkine
Pharmaceutical (INKP,
news,
msgs)
Noven
Pharmaceuticals (NOVN,
news,
msgs)
Triangle
Pharmaceuticals (VIRS,
news,
msgs)
Valentis (VLTS,
news,
msgs)
We
plan to wait for a nice down day and then add ATS
Medical (ATSI,
news,
msgs)
and Bruker Daltonics (BDAL,
news,
msgs)
to our portfolio.
REITs. Some 350 readers took
advantage of our offer last week to send Barry Vinocur’s list of
REITs with a good chance of maintaining their dividends. The list is
still available by writing gbuch@bloomberg.net. Also,
feel free to send us queries for Dr. Real Estate or Dr. Merger.
Include compliments and criticism of our work, as this is how we
learn. We respond to all communications.
At the time of
publication, Victor Niederhoffer and Laurel Kenner owned shares of
the following equities mentioned in this column: Avant
Immunotherapeutics, Cima Labs, Columbia Laboratories, Cooper Cos.,
Cyberonics, DOR BioPharma, Eclypsis, Guilford Pharmaceuticals,
Genelabs Technologies, Inkine Pharmaceutical, Noven Pharmaceuticals,
Triangle Pharmaceuticals and Valentis.
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