Prices and Earnings Diverge

According to FactSet, since June 1, the price of the S&P 500 index has increased by 6.4%, while the year-over-year earnings growth rate for Q3 has declined from +3.5% to -1.6%.  In other words, while analysts were reducing their earnings growth rate forecasts for Q3 2012 by 5.1%, the S&P rallied by 6.4%.  This represents an astonishing 11.5% divergence between earnings expectations and the price of the index.

Q3 Earnings Estimates

FactSet provides a weekly earnings summary in a free PDF file on their website; it contains a wealth of information.  The above statistics are from their latest report dated July 27, 2012.  In that report, you will also find a graph of the S&P 500 price and earnings data for the last four months.  I encourage you to download the PDF file and review the graph and data in detail.  The price-earnings divergence is even more obvious in the chart. Unfortunately, this is not just a divergence problem. The earnings estimates for Q3 have been decreasing at an increasing rate.  Earnings estimates do not appear to be leveling off.

The latest year-over-year earnings growth rate for Q3 has fallen to -1.6%.  This is indicative of a recession.  Based on Standard and Poor's data, the last time year-over-year earnings growth was negative was from 9/30/2007 through 6/30/2009.

Given the steep, negative trajectory of earnings estimates for Q3, it seems unlikely that earnings estimates will begin to rise in the near future.  As a result, the only practical way to eliminate the divergence between price and earnings would be for the price of the S&P 500 index to decline.

Central Bank Influence

However, with the Fed and ECB meetings next week, the bulls may be able to drive equity prices higher - at least until the central bank announcements.  The Fed is expected to implement some form of stimulus - possibly QE3 and/or a reduction in the deposit rate earned by member banks. Unfortunately, interest rates are already at historic lows.  Additional monetary stimulus may temporarily boost equity prices, but will have little if any lasting effect on the economy, earnings, or the market.

Mario Draghi fueled the markets last week with his comment that "the ECB is ready to do whatever it takes to preserve the euro," implying the ECB would consider purchasing Spanish and Italian bonds.  Predictably, yields on Spanish and Italian debt declined last week.  Unfortunately, these effects will be short lived as well.  The ECB may be able to drive down rates briefly on the margin, but in the absence of a permanent, fundamental solution to the European debt crisis, these effects will be temporary.

 Q2 Earnings and Revenue

Here is the latest Q2 earnings update from FactSet:

"To date, 265 companies in the S&P 500 have reported earnings for Q2 2012. Of these 265 companies, 71% have reported actual EPS above the mean EPS estimate, while 29% have reported actual EPS below the mean EPS estimate."

"In terms of revenues, just 43% of companies have reported actual sales above estimated sales. Over the past four quarters, 63% of companies in the S&P 500 reported actual revenue above estimated revenues on average. If the final percentage of companies reporting sales above estimates is 43%, it will mark the
lowest percentage for a quarter since Q1 2009 (37%)."

"Of the 60 companies that have issued EPS guidance for the third quarter, 47 have issued projections below the mean EPS estimate and just 13 have issued projections above the mean EPS estimate. Thus, 78% of the companies issuing guidance to date for Q3 2012 have issued negative guidance."

As I have reported before, the bottom line earnings look reasonable, but the top line results (sales) tell a different story.  Sales are much more difficult to manipulate than earnings and only 43% of reporting companies have beat their sales estimates, a level not seen since the end of the Great Recession.  Negative earnings guidance has grown dramatically over the last few quarters and is currently 78% - which is greater than a 3.5 to 1.0 ratio.


Examining economic releases such as personal income and retail sales is helpful, but earnings drive stock prices. And the trend in earnings is negative.  The central banks will continue to roll out new stimulus packages, but monetary policy will not solve the problems of the global economy.  Bernanke and Draghi have both commented on the limited effectiveness of monetary policy and on the need for meaningful structural solutions.  Unfortunately, structural solutions take time and are difficult and sometimes impossible to implement due to competing political factions.

I am not a perma-bear, but it appears increasingly likely that we are already in a recession and the economy will get worse before it gets better.  If you are still bullish, I would encourage you to use stops to protect your gains and to monitor your favorite technical and fundamental indicators closely for any further signs of weakness in the markets or in the economy.  There is nothing worse than riding your winners from the peak of a bull market to the trough of a bear market


Your comments, feedback, and questions are always welcome and appreciated.  Please use the comment section at the bottom of this page or send me an email.

Do you have any questions about the material?  What topics would you like to see in the future?


If you found the information on www.TraderEdge.Net helpful, please pass along the link to your friends and colleagues or share the link with your social network.

The "Share / Save" button below contains links to all major social networks.  If you do not see your social network listed, use the down-arrow to access the entire list of social networking sites.

Thank you for your support.

Brian Johnson

Copyright 2012 - Trading Insights, LLC - All Rights Reserved.




About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years. I have also written four books on options and derivative strategies.
This entry was posted in Economic Indicators, Fundamental Analysis, Market Commentary, Market Timing and tagged , , , , , , , , , . Bookmark the permalink.

Leave a Reply

Your email address will not be published. Required fields are marked *