When the last company dispatches its numbers for the quarter just passed, S&P 500 earnings will have risen by 13.6%, or so predicts First Call/Thomson Financial, via RTTNews. That would mark the 17th straight quarter of double-digit gains. As fundamentally driven tailwinds go, it doesn’t get much better than this for the stock market. So why is the S&P 500 slumping these days?
The highs for the year were set back in early May, when the S&P 500 closed above 1320 for four straight days. As of Friday’s close, the index has fallen about 6%. Technically, the market doesn’t look inclined to turn around any time soon: each rally since May has brought a lower peak than before.
Whatever ails the stock market, no one can say that weak earnings are to blame. But as the bears are quick to point out, there is any number of other reasons to sell these days, ranging from geopolitical tension to fears that an economic slowdown is coming.
But the bulls shouldn’t despair, writes Milton Ezrati, senior economic and market strategist at Lord Abbett. If equities moved sideways for the rest of this decade, as some predict, that would make this decade’s stock market performance since the 1930s, he observes in a research note published Friday. “If the popular forecast is correct and the S&P 500 were to show no further gain thorough the end of the decade,” he asserts,

the market would have no better performance than the Great Depression—an unlikely event, to be sure, especially in light of today’s positive fundamentals. If the index, aside from dividends, falls short of a 14 percent annual rise during the next 3½ years, this first decade of the 21st century would fall well short of any 10-year stretch of the past 30-plus years. We believe the implication of these statistics clearly is that matters are very likely to improve going forward. History is indeed on the side of the bulls.

Perhaps, although history is a guide to the future, not a guarantee. That said, it seems likely that when the Fed is truly done with its current round of rate hikes, there will be a relief rally that lasts more than a day or two. No less was suggested last Wednesday, when stocks rose sharply after Fed Chairman Bernanke made what some thought were dovish comments about monetary policy in testimony to Congress.

But expecting stocks to surge on a long-term basis simply because the Fed refrains from further rate hikes, however, is a fool’s game. If the central bank decides it’s time to conclude monetary tightening, it’s like to be driven by the clear and persistent evidence that the economy is slowing. In turn, a weakening economy, if only on the margins, threatens the one saving grace that has kept the bulls optimistic: earnings growth.
To be sure, earnings growth isn’t about to dry up any time soon. Corporate America has become leaner and savvier over the past few years. The ability to extract profit in a world that is increasingly volatile is a skill that companies in the S&P 500 have mastered. But corporate earnings rising by, say, 6% pales next to growth of 13.6%, which is the current outlook for the second quarter. How might Mr. Market react with a material slowdown in earnings growth? If he’s not willing to buy when earnings are soaring at a double-digit pace, is he likely to be enthused if the rate of advance slows?
Meanwhile, bonds are drawing attention away from stocks by way of the yield on the 10-year Treasury that’s 5%-plus. The average annual return on stocks during 1926-2005 was 10.3%, Ezrati writes. That’s virtually the same as the 10.5% pace for 1990-2005. But some investors are deciding that a guaranteed 5% on the 10-year looks more attractive at a time of transition.
In fact, hedging one’s bets looks better still. Stocks may face a headwind in the coming months and years, but Ezrati’s number-crunching isn’t easily dismissed.
Diversification by any other name still smells as sweet.