Earnings Aren't A Reliable Market Indicator

by Paul Whitfield

Stock market indicators come in three time zones.

A leading indicator tells what’s going to happen — like the smell of pizza in a box suggests that a meal’s near.

A coincident indicator tells what’s happening now — the pizza’s being eaten.

A lagging indicator tells what happened — like an empty pizza box.

But some things don’t act as indicators at all — a pizza coupon in the newspaper doesn’t necessarily mean a meal is about to happen, is happening or has happened.

When considering indicators, it’s also important to remember that the closer a predictive value comes to 50-50, the less useful it is. You might as well flip a coin.

So where do earnings fit into this picture?

The accompanying chart shows the S&P 500’s monthly price performance from 1989 to the present and the earnings trend line. The gray areas show times when earnings fell. White areas show periods when earnings rose.

If you go through this chart on an annual basis, the results don’t show any useful pattern. From 1990 to 2005, earnings acted as a leading indicator about as often (nine of 16 years) as they acted as a coincident indicator (10 times) or a lagging indicator (nine times).

Of course, counting year by year is arbitrary and could be misleading. But looking at the major changes in earnings trend lines doesn’t lead to a much different result.

From mid-1989 to late 1991, stock prices meandered upward as earnings declined (point 1). The earnings trend line then turned up (point 2), which might suggest stocks’ predictive value or earnings’ lagging behavior.

But you could easily see the action in that second section as coincident behavior — with earnings and stock prices rising together.

The earnings decline in section (point 3) is neither predictive, coincident nor lagging in relation to stock prices. Earnings declined, but stocks rose before, during and after.

Don’t assume that because earnings are rising, stock prices will follow. As the chart shows, that’s about as reliable as a coin flip.

CAN SLIM investors don’t look at the S&P 500’s earnings when gauging the broad market’s trend. The major indexes’ price and volume action is the most reliable indicator in that regard.

The EPS Rating of an individual stock shouldn’t be treated as a timing mechanism, either. It’s still an important criterion when picking stocks to buy.

But if earnings don’t act as an indicator in themselves, doesn’t that bring into question their role in the CAN SLIM formula, namely the C for Current Quarterly Earnings and A for Annual Earnings?

No, it doesn’t.

CAN SLIM is a balanced and comprehensive approach that requires that all of the elements be in place. It’s not a one-trick pony.

Earnings growth is important, even critical. But other elements must also be in place for a stock to succeed. Look for new products and new management, increasing trading volume, strong sales growth and profit margins.

The stock should show bullish price and volume action in the form of a smooth chart. Also look for institutional sponsorship and a healthy general market.

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