The Implications of Negative Earnings Growth

Undoubtedly, the underlying driver of the U.S. stock market in recent years could be summed up in two words; earnings growth. Equities now face a hurdle, however, as third quarter profits for the S&P 500 could very well decline year over year for the first time in five years. The implications for the market are pretty important.

At the outset of the year, market forecasters were calling for low to mid double digit returns for the market, supported by rising earnings and slight multiple expansion. It was my view that multiple expansion was unlikely (due to a lack of low P/E ratios to begin with, coupled with decelerating economic and earnings growth rates), so market returns would more likely track earnings advances, which would put us up in the mid to high single digits for the year. The S&P 500 is slightly above that pace right now, but it will likely be an uphill battle from here.

The reason is that without multiple expansion or earnings growth, there is no way for the market to advance meaningfully, by definition. The end result is likely to be a range-bound market as judged by the major indices. In fact, as the chart below shows, we have already begun to see this scenario take shape.

S&P 500 Index – Last 6 Months

From an investor perspective, this infers that stock picking will be all that more crucial to achieve investment gains. Not surprisingly, I would suggest focusing on individual situations where either multiple expansion or earnings growth are largely assured. The ideal investment candidate would be set up nicely for both, which would allow for solid gains regardless of whether or not the overall market advances meaningfully in coming months.

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