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The Sweet Spot ?

Monday, February 09, 2004 | 12:33 PM

What is the market's typical reaction to very strong corporate earnings? That seems like an awfully obvious question, but the answer may surprise you.

It is counter intuitive, but true: The market does not perform at its very best when year over year earnings are accelerating the most. The best period for equities as a whole is when quarterly earnings are falling, albeit at a modest rate. That determination is the result of research covering 8 decades, first performed by Martin Zweig, and subsequently confirmed by Ned Davis Research. (See chart)

There are several possible rationales for why this is: The first is that when corporate earnings are growing at a level greater than 20%, the possibility of inflation and interest rate increases are much greater. Since equity markets tend to under perform in a rising rate environment, it makes sense that a period of very strong earnings is unlikely to produce market out performance. Indeed, an earnings period of top 20% year over year gains are more like to have been preceded by a strong rally than followed.

Another possible explanation is that the markets bottom while earnings are in the middle of the process of decelerating to accelerating. As earnings shift from bad to good is the sweetest spot of the economic cycle, from a market perspective.

Lastly, since the equities markets act as a future discounting mechanism, a very fast pace of earnings growth is typically already “baked into the cake.”

Which brings us to the present situation: According to First Call, “4Q03 earnings for the S&P500 continue to appear headed for growth that will be close to 28%. While that is the best since 3Q93, it will represent the peak earnings growth for this business cycle.” These numbers are based upon over 80% of the S&P500 companies already having reporting Q4 2003 earnings.

This does not mean that the rally is over, or that a major correction is imminent. Rather, what it suggests is that the “easy money” has already been made, and that the subsequent upside is more likely to be moderate than the torrid.

The major trend remains upwards, but the present minor correction has not yet fully run its course. A prudent approach would be to moderate your expectations for equity gains over the next few quarters.