Shares do better when year-over-year profits decline

Many investors find it surprising that, in the wake of the fastest growth rate in corporate profits in many years, the U.S. stock market is struggling. In fact, however, they should have expected it. Over the past nine decades, the stock market on average has hardly produced any gain in calendar quarters in which year-over-year earnings growth is as strong as it is currently.

That seems counterintuitive in the extreme. GAAP earnings per share for the S&P 500 are projected to be 36.7% higher than the comparable quarter of a year ago, according to Standard & Poor’s. That compares to an average of just 5.9% average annual growth since the late 1980s.

What’s not to like in that? As Mae West quipped, too much of a good thing is wonderful. But, as Humphrey Neill, the father of contrarian analysis, famously said: “When everyone thinks alike, everyone is likely to be wrong.”

Consider what the data — as opposed to intuition — tell us. Since 1927, according to Ned Davis Research, the stock market has performed the best in quarters in which the S&P 500’s earnings per share are between 10% and 25% lower than where they stood one year prior. In such quarters, the S&P 500’s average annualized return is 25.0%.

That compares to an average gain of just 2.6% during those quarters — like the current one — in which year-over-year earnings growth was above 20%.

To be sure, as you can see in the chart, below, the S&P 500’s worst average quarterly performance came when year-over-year earnings growth rates were even worse than minus 25%. Such quarters were rare, however, and if we bracket them there is a perfectly inverse correlation between earnings growth rates and the S&P 500’s performance.