Slower Earnings Growth: Fact vs. Fear

While some investors are getting anxious, a review of the charts shows that markets and earnings don't always march in lockstep

By Sam Stovall

As 2003 comes to a close, it appears that companies in the S&P 500-stock index are on track to post a 20%-plus rise in stock price and a near-20% increase in earnings. Indeed, operating earnings for the 500, which jumped 23% on a year-over-year basis during the third quarter, are projected by S&P analysts to register a 21% advance in the fourth quarter, leading to an 18% full-year gain. And the earnings advance isn't likely to end there -- S&P analysts estimate a 14% increase for 2004.

But not everyone is excited by this news. In fact, some investors are downright worried. Not that they expect absolute earnings to decline, but they're concerned that a sliding rate of earnings growth may cause the market to begin giving up ground. Take a look at showing the S&P 500 outfits' quarterly year-over-year change in actual and estimated operating earnings.


  We believe that the 23% year-over-year earnings rise in the third quarter will likely be the near-term peak in the earnings-growth rate. But while the pace of increase is expected to slow in the coming quarters, the absolute level of earnings is projected to continue rising, at least through 2004. What's more, should the S&P 500 post operating earnings of $61.50 in 2004, as we anticipate, it will mark a new high in full-year earnings, surpassing the prior record of $56.13, established in 2000.

Even though this factoid may not be enough to quell investors' fears regarding a slowing growth rate, maybe history will. Take a look at which traces the 40-year trend in year-over-year changes in GAAP, or "as reported" earnings for the S&P 500, and identifies the price change of the index as earnings decelerated from peak to trough or to just above the 0% level.

As the table immediately below more clearly summarizes, from June, 1988, through September, 1989, while earnings for the S&P 500 went from a 50.3% expansion rate to a 4.3% year-over-year increase (earnings fell 3.7% in the December, 1989, quarter) the S&P 500 posted a price advance of 28%. In addition, after each of the 10 earnings-peak observations, the S&P 500 posted price advances six times and declined four times. For all observations, the S&P 500 gained an average 7%.

Rate of EPS growth and price change after earnings cycle peaks-- S&P 500
Periods Start End % Price Chg.
3/66-3/67 14.1% 2.1% 1%
12/68-12/69 8.1% 0.3% -11%
12/73-3/75 27.1% 0.7% -15%
12/76-6/78 27.7% 7.8% -11%
9/79-9/80 26.4% 0.1% 15%
6/84-3/85 28.7% 7.4% 18%
6/88-9/89 50.3% 4.3% 28%
3/95-6/96 43.3% 1.4% 34%
3/97-12/97 18.2% 2.4% 28%
3/00-12/00 32.8% 3.8% -12%
Average 27.7% 3.0% 7%


  So should investors automatically worry about share prices declining once earnings' growth rate begins to slow? Not necessarily. Other factors must be taken into consideration.

The two straight arrows in emphasize the greater width of earnings swings over the entire period. This observation seems counterintuitive at first glance, especially since investors have assumed that the business cycle has contracted over time. In addition, as the U.S. economy has become more service-oriented, one would expect to see a less volatile trend in earnings.

The precipitous earnings fall-off in 2001 was due, in our view, to the unprecedented amount of write-downs and restructuring charges taken as a result of the faltering economy and the required accelerated write-downs of accumulated goodwill. The reasons behind the other exaggerated profit expansions and contractions, however, may be a bit less clear.


  As seen in the table immediately below, the answer may lie in the actual makeup of the S&P 500 and the growing influence of financial and technology issues in the index. Back in 1970, the financial sector was almost nonexistent within the 500 due to the strict limit of 40 financial companies. Also, many of the behemoth financial-services firms of today were private organizations 30 years ago. As time passed, however, the financial sector grew to more than 14% in 2000, and today it's now the largest sector within the S&P 500, representing more than 20%.

Changes in sector weightings (%) in the S&P 500
Sectors Aug., 2000 Sept., 1970 % Chg.
Consumer Discretionary 9.8 16.5 -41%
Energy 5.5 15.7 -65%
Financials 14.4 0.8 1,702%
Health Care 10.7 4.8 122%
Industrials 9.5 16.6 -43%
Information Technology 33.6 11.5 192%
Materials 1.8 10.0 -82%
Telecom. Services 6.0 5.9 2%
Utilities 2.7 7.9 -65%
Consumer Staples 6.0 10.3 -42%

The S&P Information Technology sector -- renowned for its earnings cyclicality -- represented less than 12% of the market value of the S&P 500 in 1970 and declined to less than 8.5% of the 500 in 1995. Five years later, however, the tech-sector index accounted for more than 33% of the S&P 500's market value. Today, tech represents 18% of the S&P 500.


  S&P's Investment Policy Committee still looks for the S&P 500 to close out 2003 at or near 1,085, implying a 2.6% advance for December and a 23% rise for the entire year. And while a 2.6% rise would be asking a lot from the average month (the index has risen an average 0.7% during each month since 1945), it appears to be less of a hurdle for December. After all, it's the strongest month of the year, which has posted an average increase of 1.8% since 1945 and has risen more than 75% of the time.

Our 2004 closing target for the 500 is 1,190, indicating a 10% advance in the coming year. Factors that contribute to this optimistic (but not, we think, Pollyanna-ish) outlook include a strengthening economy, rising corporate earnings, and the lack of attractive investment alternatives to equities.

Slower Earnings Growth: Fact vs. Fear

Slower Earnings Growth: Fact vs. Fear

Stovall is chief investment strategist for Standard & Poor's

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