Stock Market (Photo credit: Tax Credits)

August 5

Who Knew ?  - Will Not Be The Excuse Of AMP Readers  ( underline your AMP Book as you read)

The stock market and earnings analysts do not expect a decline in EPS over the next few years. The forecasts too often anchor on the recent past and extrapolate (in a burst of hope) current trends well into the future.

A broader view of history tells a different story. It is a story of a frequently erratic earnings cycle. The current cycle is now extended not only in duration but also in magnitude. It’s hard to deny that EPS is vulnerable to decline over the next few years.

When the decline in earnings occurs, it will not be minimal. The decline to the historical average would be 30% to 40%. These cycles, however, rarely stop at average. More often, they move well above and below the long-term trend line.

We’ve all seen that the stock market reacts to surprises quite negatively. There is no reason why investors should walk blindly into this storm. “Who knew?” will not a reasonable excuse.

What about the duration of earnings cycles? Past EPS cycles have lasted one to six years. Over the past six decades, there have been twelve up-cycles. Six lasted one or two years (last year, 2011, was year three of the current cycle). We’re now in the second half of the game. As each upcoming year passes with an increase in EPS, the likelihood rises for the next decline in EPS … and potentially the stock market.

Conclusion #1: Reported earnings, based on history, should be expected to decline over the next two years (or they are increasingly likely to disappoint current expectations). That will put pressure on the stock market. If history is a guide, and if the blue line in Figure 8 only slightly retreats below the historical baseline, the implication is a decline in reported EPS of almost 40%! While growth could continue (as it has done in the past), it is clear that this cycle is getting a little weathered. And note that almost every downturn came as a surprise to the markets. Any analyst suggesting a downturn is labeled doom and gloom (as we can attest).

Conclusion #2: The measures of P/E that are based upon reported EPS are currently distorted by the business cycle. Whereas current reports have the market’s forward P/E near 13, a more rational measure for P/E based upon normalized baseline EPS is close to 20. P/E is not below average and is not ready to propel the market upward; it is well above average.

Of the twelve up-cycles, half of them ended after one or two years of rising earnings. None of them exceeded six years, and only one went that long. Since 2011 was the third year of earnings gains for the current cycle, the likelihood of a decline is increasing. If a decline happens to not occur during the coming two years, then we’ll make history.

A weak economy, however, adds to the pressure on earnings. The typical vulnerability at this level in the cycle is accentuated by the external forces of the economy. That makes the risks particularly worrisome.

It’s Time to Think About Absolute Returns

As described in chapter 10 of Probable Outcomes and chapters 9 and 10 of Unexpected Returns, the goal is to use absolute return-oriented “rowing” investments rather than more passive relative return “sailing” strategies. Although the stock market will provide shorter-term periods of solid returns over the next decade, it will also have offsetting periods of declines. Unlike secular bull markets, where the upswings far outweigh the downdrafts, the current environment is set for a much more modest (and likely disappointing) result. Rather than acquiesce to the mediocre returns on the horizon, investors can take action and develop their portfolios to profit regardless of the overall market direction. Although market timing may be an option for some, it is generally not a good option for most investors.

Conclusions About the Earnings Cycle

The business cycle has endured for well more than a century. It generally delivers two to five years of above-average EPS growth before experiencing a year or two of pullback. We have had a dramatic run over the past two years, and the forecast for the next two years now positions profits well above their historical relationship to the economy.

Several factors now indicate that a period of EPS decline may be upon us. It does not necessarily portend a decline in the market, although that vulnerability clearly exists. Beware nonetheless! For investors, this means that portfolios should be positioned through diversification and active risk and return management.

As an analogy, winter is not a time for gardeners to hibernate; rather it’s a time for different crops and techniques than you employ in spring or summer. And let’s be certain about this: there will be a new spring, and I will turn bullish – probably too soon! – as we begin to see signs of a thaw in the markets. But for now, investors have many tools available that let them actively “row” and invest like institutions, thereby achieving relatively consistent returns with a lot less disappointment risk.