Analysts predict Standard & Poor’s 500 Index profits are about to decrease for three straight quarters. Investors better hope they don’t.
History shows that once earnings drop for that long, they almost always keep falling, and usually take the market with them. In fact, among 17 declines that got to nine months since the Great Depression, exactly one stopped there, in 1967.
Any sign that U.S. earnings are about to collapse is enough to strike fear in money managers who have watched shares triple as profits rose almost every year since 2009. Even if analysts are right about the duration of the skid, earnings contractions of three quarters or more have triggered bear markets 82 percent of the time over the past eight decades.
“Analysts and investors are notoriously bad at calling a turning point,” said Rich Weiss, the Mountain View, California-based senior portfolio manager at American Century Investment, which oversees $150 billion. “They typically want to believe earnings can continue to surprise on the upside and see the trend continue. This is unlikely.”
Among S&P 500 members, combined quarterly profit growth has turned negative in 33 instances since 1937, data compiled by Bloomberg and S&P Dow Jones Indices show. While half of them lasted no more than six months, the others almost always dragged on, spanning five quarters on average. Out of the 17 occasions where earnings fell for at least three quarters, 14 occurred within three months of a bear market.
The S&P 500 advanced 1.2 percent at 4 p.m. in New York, capping the first back-to-back daily gains since Feb. 17.
Right now, investors may face the longest stretch of profit declines since the 2008-2009 financial crisis, according to analyst estimates compiled by Bloomberg. Earnings are forecast to shrink 5.8 percent in the first quarter of this year and fall 4.2 percent and 1 percent over the next two, the forecasts show. Without energy’s drag, income would rise.
“Is this the signal that the earnings cycle is over?” said Bill Stone, chief investment strategist at PNC Wealth Management from Philadelphia. The firm helps oversee $136 billion. “If you’re paying a relatively high multiple, that’s what you should worry about.”
Alcoa Inc. will start the earnings season next week. Oil companies are expected to post the worst first-quarter results among 10 S&P 500 industries, with profit dropping 63 percent, analysts’ estimates compiled by Bloomberg show. A combination of faltering demand and booming supplies from North American shale fields has driven crude prices down more than 50 percent.
Income from four other groups, including producers of household goods, are also forecast to fall, partly because the dollar’s ascent hurt sales for firms like Procter & Gamble Co.
While oil tends to plunge during recessions, crimping earnings amid shrinking demand, there have been two other occasions where prices fell more than 32 percent from peak to trough and the economy grew: 1984-1986 and 1998-1999, according to Ed Clissold, U.S. market strategist at Venice, Florida-based Ned Davis Research. Both times, profits contracted for five quarters.
Stocks fared well in 1986, with the S&P 500 rising 15 percent for a fifth yearly increase. In 1998, the benchmark index suffered a 19 percent retreat from July to August as Russia devalued its currency on the heels of the Asian financial crisis.
“The question from here is, do you think the climb in earnings is going to slow down and we’re going to turn back up, or do you think earnings are going to get a lot worse?” Clissold said. “Another round of earnings expectation cuts that gets beyond due to oil and the strong dollar could be problematic.”
Earnings momentum is in jeopardy just as nine quarters of equity gains pushed valuations toward a five-year high. At 18.5 times profit, the S&P 500 trades at almost the highest multiple since 2010 and compares with the average of 16.9 since 1937.
The earnings shock from oil and dollar will be short-lived as long as economic growth stays on track, according to Doug Foreman, chief investment officer at Kayne Anderson Rudnick Investment Management.
Gross domestic product in the U.S. will expand at the fastest rate in a decade, rising 3 percent this year, according to economist estimates compiled by Bloomberg. Growth has been stuck at 2.5 percent or below since 2010.
“It’s hard to make a case for earnings to decline in some huge magnitude” in the absence of a recession, said Foreman, whose firm oversees about $9 billion in Los Angeles. “If you have a few quarters of negative growth rate because of things like currency and energy falling out of bed, I’m not sure that has any lasting impact. It may be a trigger for a correction, but it’s not a deal breaker.”
As earnings estimates deteriorate, chief executive officers have accelerated share buybacks, a strategy that has boosted per-share profit at a time when sales prove harder to come by. More than 120 companies, including Home Depot Inc. and Comcast Corp., in February announced a record $104.3 billion in planned stock repurchases, according to TrimTabs Investment Research.
At the same time, near-record low interest rates and stagnant pay, which have enabled CEOs to increase profit by an average 15 percent a year since 2009, or three times faster than sales, are poised to end as the Federal Reserve prepares to raise interest rates amid an improving labor market.
Operating margins for S&P 500 companies, the difference between revenue and expenses, slipped to 9 percent in the final three months of 2014 after climbing to a record 10.1 percent in the third quarter, data compiled by S&P show.
Concern U.S. executives have run out of ways to increase income are emboldening bears. Clients of exchange-traded funds have pulled about $12 billion from U.S. equities this quarter and added $39 billion to international stocks, a reversal from the last two years, when money flowing to the U.S. was more than double that going elsewhere.
The percentage of global money managers who are underweight American equities is the highest since 2008, according to a March 6-12 poll by Bank of America Corp. A net 35 percent of respondents in the survey picked the U.S. as the worst place to invest in the next 12 months, the most in almost a decade.
“When people aren’t going to feel as positive about the market because they are seeing earnings trending lower, that tilts the table towards more selling,” said Michael Ball, president and lead portfolio manager of Colorado-based Weatherstone Capital Management, which oversees $750 million. “I wouldn’t say automatically that alone brings the market down. It certainly makes it more susceptible.