Stock Market when EPS Growth Turns Positive

By Spencer,

Unless the economy-market is on the verge of a major unforeseen calamity S&P 500 earnings per share growth will turn positive in the fourth quarter. Generally analysts are positive on the market because they expect very strong earnings growth in 2010. This will be the twelfth time since 1950 that earnings growth has turned positive.

Even if you make extremely conservative projections, EPS growth in 2009 will be very strong. In the first two quarters already reported EPS was in the $14-$15 range. If you assume that EPS will be in this same range in the second half of the year it generates an estimated EPS growth for 2009 on the order of 50%.

On average, in the previous eleven times, the market was virtually flat. But this flat average was a product of six significant declines or bear market and five rising or bull markets. The average contains almost 25% drops in 1961 and 1987 and a 20% rise in 1968.

I guess this is the time to talk about the 6′ economist who drowned fording a stream where the average depth was 3′.

Since 1950 the market has been above its year ago level some 72.5% of the time. But in the first year after earnings growth turned positive, the market is only up 45% of the time. So one of the most dangerous times in the market is in the first year after earnings growth turns positive. It is another consequence of the point that the correlation between the change in earnings and the change in the market is essentially zero.

The difference between rising and falling markets was not earnings growth. On average, in the six years the market fell earnings rose 19% and in the five years the market rose earnings rose 16%.

Rather, the difference was between valuation and the impact of rising interest rates.When the market fell, bond yields rose while when the market rose, yields fell. In general the relationship between the market PE and bond yields is roughly one-to-one. That is, a 100 basis point rise in yields generates roughly a 100 basis point fall in the market PE.

But when the market is overvalued, as it is now, rising interest rates can have a much more severe impact as the market quickly eliminates its’ overvaluation as it did in 1961 and 1987.

The current rally is being driven by the liquidity the Fed has flooded the system with over the past year. But in 2010, if the economy is rebounding, and particularly if growth is stronger than expected, the Fed will be under intense pressure to drain this liquidity. Some Fed spokesmen are already warnings that rates could rise rapidly over the next year.

PS. I’m posting this late Thursday afternoon, but will not be able to respond to comments until Friday afternoon.