Percentage Change in Earnings v. Subsequent 12 month S&P500 performance, January, 1945- May, 2007

Percentage Change in Earnings v. Subsequent 12 month S&P500 performance, January, 1945- May, 2007:

An interesting relationship exists between the percentage change in earnings for the S&P500 (earnings this year divided by earnings 12 months ago) versus subsequent 12 month performance of the S&P500; it turns out this is an inverse relationship. The market performed best during periods of contracting earnings.

Earnings change, year-over-year, versus next 12 month change in the S&P 500 , January, 1945-May, 2007, n = 725:
		Earnings yield		Next 10 year return (annualized):
Percentiles:	n	From:	To:
Min-25%	182	-53.63%	-1.92%	9.72%
25-50%	181	-1.92%	9.10%	8.12%
50-75%	181	9.10%	16.01%	10.31%
75-Max	181	16.01%	88.58%	6.64%
		Correlation:		0.8%
All:	725		Average:	8.70%

The main point here is that periods of strong earnings growth are not necessarily followed by strong changes in the S&P 500. The top quartile of earnings growth (anything above 16% year-over-year change in earnings) was followed by a below average 6.64% average S&P rise. Conversely, the lowest quartile, when earnings were declining by 1.92% or more, led to above average subsequent returns of 9.72%. The best time to buy the market would have been when the S&P 500 was rising between 9.1 and 16.0%, during which period the market rose 10.3%.

However, the correlation is an extremely weak .008, so change in earnings should not be used as a market timing tool, despite all the attention paid to it by analysts and the financial press. If one uses this change at all, it should be as a contrary indicator. Simply because earnings have been falling does not mean you should lose interest in stocks. When they have been rising faster than 16% on a year-over-year basis you should grow a bit cautious.