ETFOptimize Insights

Data-driven Analysis of Critical Market Indicators that Determine Strategy Timing and Selection


Earnings Analysis
"ETFOptimize Insights" is our regular analysis of changes to the critical indicators that determine market exposure and ETF selection for our Premium Strategies.


The Coming Earning Slowdown


• As-Reported Trailing Twelve Months (TTM) S&P 500 Earnings continues to climb at a brisk pace.

• Current Fiscal Year EPS Estimate (Current FYEPSMean) and Next Fiscal Year EPS Estimate (NextFYEPSMean) chart are also still climbing, contrary to the anecdotal warnings from pundits.

• Our Progressive-Blend Earnings Composite (PBEC) indicator has a highly accurate track record for predicting near-term equity prices, and at this time it shows no evidence of a decline.

• Based on earnings alone, the US economy and nine-year-long bull market remains intact for the foreseeable future.



Ubiquitous Predictions of an Earnings Slowdown

Pundits spent the month of October, fishing for clicks as the market languished, by devising a sizable list of reasons a slowdown was imminent and was the source of the selloff. These rationales included the 'Trump trade war,' the Fed hiking too aggressively, a strengthening dollar, declining car sales, higher labor and raw materials costs, the slowing of China's domestic economy, an oversupply of oil, slowing home sales. However, the one factor that is perhaps the most tangible is that there will definitely not be another massive, US corporate tax cut in 2019 to match the one in 2018.

Of course, the impact of each of these factors that that could cause a reduction in year-over-year corporate earnings growth – one of the fundamental drivers of stock prices. But is there clear evidence that a slowdown is inevitable? Or is it just nervous worry – without basis in fact – during a month-long correction coming after such a very long bull market? After all, by some measures the current bull market is the longest ever – at 3,533 days and a gain of 312%. It just has to be coming to an end soon, right?

That last question requires far too much reliance on subjective opinion for this writer's taste. Our firm focuses on building high-profit, quantitative investment strategies based on various combinations of as many as 38 fundamental data series, and we maintain a disciplined avoidance of the investment industry's rampant use of 'expert opinion' to fuel discretionary investment decisions. Instead, we advise investors to rely 100% upon carefully crafted, quantitative indicators that provide high-probability signals in our high-performance investment strategies.

In many instances, these key indicators provide investors with very different information that what they might be reading in the financial media or hearing from the 'experts' on television. In fact, according to one of our key indicators – our Progressive-Blend Earnings Composite (PBEC) – at this time there is no reason to fear an imminent slowdown in earnings at all. In this article, we will break down our PBEC into its past, present, and future components to demonstrate that objectively, signs of an earnings slowdown in the coming months – so far – are nowhere to be found.

A Robust Correlation Between Earnings Trends and Price Trends – with a Caveat

Theoretically, earnings drive the performance of stocks. A quick chart analysis of the correlation of long-term as-reported, quarterly earnings trends to stock price trends confirms that stock prices trend do, in fact, possess a material correlation with earnings trends, but only over significant periods of time.

Chart 1 below demonstrates this dynamic by displaying the 1) S&P 500 index from 1925-present in the top window (black line), the 2) as-reported, S&P 500 quarterly GAAP earnings in the second window (green line), the 3) one-year (4-quarter) correlation between the two in the third window (red line), and the 4) 10-year (40-quarter) correlation between the two series in the bottom window (blue line).

Chart 1: The correlation between stock prices and earnings is only consistent in the long term (5+ years) and very inconsistent on a short-term basis.


It's clear from Chart 1 above that in the short term (one-year, red graph), there is a very poor correlation between stock prices and earnings in the short term (one year or four quarters). However, the bottom window (blue chart) shows that, with the exception of the World War II years and the mid-1970s (both times of significantly high inflation that affected the relationship between earnings and prices) the long-term, 10-year correlation between earnings and prices is quite high and consistent since the S&P 500 index was launched in 1925.

Over the past 35 years – since 1983 – the long-term,10-year relationship between earnings and stock prices is quite robust and stable at an average correlation of about 0.76. However, we find that only during periods of five years or more does this significantly positive correlation become apparent. In the short term, there are an enormous number of factors that create supply/demand influences which have an effect on the price of equities and disrupts the relationship.

Experienced investors might point out here that stock prices theoretically reflect a discount of a corporation's future prospects, so a company's reported quarterly earnings growth is not the most important earnings-related factor affecting stock prices. In fact, the above analysis shows that there is, indeed, a poor short-term correlation between the two. As an obvious anecdotal example, consider the rotten performance of the S&P 500 throughout 2018 – at a time when those high quarterly growth rates averaging 23% have been occurring.


PBEC: Using Using Multiple Earnings Series to Form a Highly Accurate Market Indicator

Over the last 20+ years, our firm has developed 38 critical data series

that we use in various select combinations to construct highly accurate, low-drawdown, quantitative strategies that provide investors with multiple approaches to attain exceptional returns. These data series exploit the most critical drivers of performance across a range of applications. We combine these indicators and data series into composites that provide sound market signals.

Our relentless effort to identify these critical drivers, indicators and data series has paid off with significant real-time results. In this and future articles, we will be presenting and analyzing the signals provided many of the indicators used in our ETF-based investment strategies, serving the dual purpose of 1) illuminating the likely direction of stocks in the near-term and 2) helping investors better understand the reasons why quantitative investment strategies are so effective.

The last 20 years of highly focused analysis has uncovered the most critical drivers of market performance and has revealed that one of the most consistent is corporate earnings, and more specifically, that a change in the trend of corporate earnings can be an accurate signal for portfolio construction.  Related to earning, we discovered that there is one unique earnings-indicator configuration that performs exceptionally well with near-term, predictive accuracy.

There are a variety of ways to identify earnings trends, but they usually fall into the categories of either 1) Retrospective – the trailing 12-month's (TTM) year-over-year quarterly growth comparisons, or 2) Prospective – consensus quarterly earnings forecasts, i.e., 'Next Year's EPS Mean.'

We find that the most accurate earnings-based, near-term S&P 500 indicator is 3) a Progressively Blended Combination - a composite of Retrospective (TTM), Current Year Estimates, and Prospective (Next Fiscal Year) earnings estimates. We call this indicator the Progressive Blend Earnings Composite (PBEC), because as each quarter passes, it adds a larger percentage of next year's mean estimate to the current year's mean, and progressively decreases the weight of the trailing twelve months (TTM), as-reported earnings.

Data: To ensure accuracy, we use high-quality, point-in-time (PIT) data from Compustat and S&P Capital IQ Estimates, delivered via Portfolio123, to derive both data series. The result is a highly accurate, near-term indicator that is closely correlated to S&P 500 prices – offering the appropriate amount of lead time to allow position changes and make a difference.

In this article, we will show you the current individual charts of the 1) Retrospective S&P 500 EPS - (TTM) As-Reported Earnings, then the 2) Current S&P 500 EPS Mean, followed by the 3) Prospective S&P 500 EPS - Next Year's Mean Earnings Estimate, and finally, the last chart will show the PBEC, a 4) Blended Combination of Retrospective/ Current/Prospective S&P earnings. To provide additional detail, we have also included a 12-month Zoom into the Blended EPS Combination (PBEC).

Series 1: S&P 500 Trailing 12-Month EPS (TTM)

We believe it is critically important to use point-in-time (PIT), snapshot data, which is an exact copy of the data as it was released to the public at each moment in time – without retrospective adjustments. The data is not revised as new information is obtained, which allows us to accurately model for investment decisions based on the input that was available at any point in time - without revisions, and without modeling with a current S&P 500 universe that has an inherent survivorship bias.

The first component of our PBEC indicator is the S&P 500 quarterly-reported TTM earnings at each point-in-time, as they were released, from 2000 to present. The Series 1 chart below provides this indicator (shown in red) and the S&P 500 index shown in the background (in dark blue):

S&P 500 Trailing 12 Months EPS (Point-in-Time)
Series 1: Point-in-Time S&P 500 Trailing 12 Months (TTM) Earnings, 2000-2018.

Click here to open a zoom of the last 12 months of the Series 1 chart above.

Series 2: Near-Term Earnings - Current Fiscal Year's EPS Mean Estimate (SPEPSCY)

The data series shown in Series 2 chart below shows S&P 500 Earnings Estimates for the Current Fiscal Year (CY) in red - as the estimates were made available to investors at any given time between 2000 and present. Obviously, at the beginning of each year, the Current Year estimate is at its most speculative status, and as quarters progress through the year, the CY estimate becomes more accurate because they include progressively more of as-reported earnings.

Series 2: Point-in-Time Next Fiscal Year Earnings Estimates in red, 2000-2018.

Click to see a zoom
of the last 12 months of the Series 2 chart above.

Series 3: Prospective Earnings - Next Fiscal Year's EPS Mean Estimate (SPEPSNY)

The Series 3 chart below shows S&P 500 Earnings Estimates for the Next Fiscal Year - as the estimates were made available to investors at any given time between 2000 and present.  We consider this type of Point-in-Time (PIT) data to be critical for the development of sound quantitative investment strategies.

Prospective Next Year's EPS Estimate (PIT)
Series 3 chart: Point-in-Time Next Fiscal Year EPS Estimates, 2000-2018.

You can see that at the beginning of each quarter, analysts appear to be consistently over-optimistic about next year's earnings (ostensibly to support the self-side brokerage staff in attaining customers, which pays the bills). Then those analysts systematically reduce their estimates as each quarter progresses.

This dynamic is displayed in the chart above as the red indicator line shoots sharply higher at the beginning of each quarter and then gradually declines as the earnings estimates are revised downward. Three months later, analysts start the next period of overoptimistic earnings-releases, revise downward, rinse, and repeat. This dynamic has been intact probably since the first analyst-broker-investor intellectual ménage à trois began as far back as a century ago.

Click to zoom and see the last 12 months of the Series 3 chart above.


The Composite includes: Series 1 (As-Reported (TTM) Actual Earnings), Series 2 (Current Fiscal Year Mean Estimate), and Series 3 (Next Fiscal Year Mean Estimate

The Series 4 chart below blends the three charts above (reported TTM earnings, Current Fiscal Year Mean Estimates, and Next Fiscal Year Mean Estimates) into a single indicator chart. The proprietary algorithm developed for this composite indicator progressively utilizes less of the As-Reported TTM earnings and more of the Next Year Estimates factored in as each quarter progresses through the year.

This composite has a significant correlation coefficient with near-term S&P 500 prices and provides an accurate measure of the health of large-cap corporate earnings.

Blended EPS Combination
Series 4 chart: The Progressive Blend Earnings Composite (PBEC) is shown from 2000-2018.

A quick review of the chart shows how accurate it has been at predicting the near-term price of the S&P 500.  Notice that when the Earnings Composite (PBEC) indicator begins to turn downward, it is soon accompanied by a downturn in stock prices. However, as long as there was no downturn in the Earnings Composite, there was no downturn in the S&P 500 price.


And lastly, the Chart below shows a zoom into the final 12 months of the PBEC indicator displayed in the previous chart above - i.e., a progressively blended combination of Series #1 (TTM Earnings per Share), Series #2 (Current Year's EPS Mean Estimate), and Series #3 (Next Year's EPS Mean Estimate). Of the charts on this page, investors will find this one to be the most valuable because it offers a highly accurate indication of near-term S&P 500 prices.

12-mo Zoom into the Blended EPS Combination
A 12-Month Zoom of Progressive Blend Earnings Composite (PBEC) is shown by the red line. At this time, the indicator continues to climb, and no weakness is indicated.

Notice in the upper far right, the red indicator line shows that the Progressive Blended Earnings Composite (PBEC) indicator continues to rise, and currently indicates no evidence for an imminent weakness in stock prices (which requires a downturn in the composite indicator). 

While most recent 'step up' in quarterly earnings is clearly less than, for example, the growth between fourth-quarter 2017 to first-quarter 2018, there is no sign of a downturn in corporate profits. As we pointed out in the last section, historically it has required a decline in the PBEC indicator for there to be a significant downturn in S&P 500 prices. In these situations, any contraction by the market – as is occurring now– is likely to be a buying opportunity.


No Earnings Slowdown in Sight (Yet): Despite the widespread warnings by professionally trained analysts and armchair pundits throughout October, renewed again over this past weekend, there has yet to be any indication of a slowdown from any of the three earnings-data series component charts or the Progressive Blend Earnings Composite (PBEC) chart presented above.

Market analysts say that investors should expect significantly lower earnings in the coming quarters – especially Q1 and Q2 of 2019. They conjecture that this slowdown in growth will be a consequence of the artificially-increased earnings growth for American corporations following the one-time corporate tax cut that began in early 2018. However, our cold, quantitative analysis of earnings, which is devoid of any bias, shows that regardless of this anecdotal forecast, profits continue to grow at a brisk, healthy pace.

Nevertheless, please keep in mind that the bullish conclusion implied by the charts in this article is not intended to be a green flag to unleash aggressive, unbridled equity accumulation. Investors are counseled to use a variety of non-discretionary measures – such as we use in our proprietary investment models – to determine exposure to market risk and the appropriate selection of individual ETFs. Investors should also be prepared for a technical retest of the October lows before the fundamentals of the market reassert their dominance. Technicals determine the short-to-medium-term performance of stocks, while fundamentals determine the medium-to-long-term performance of equities.

Our quantitative strategies, available by low-cost subscription, combine a variety of indicators with different perspectives on the market to provide investors with high-probability market-risk signals, exposure guidance, and the optimum ETF selection for any point in time. The information on this page suggests that, for the time being at least, corporate earnings should not be one of an investor's concerns.

I am confident that in response to this article, the case will be made that while not here yet, a slowdown is coming. But our policy is never to assume that the rampant speculation rife in the investment industry is in any way, shape, or form accurate. Discretionary decisions, reliant on opinion, are a terrible basis for investing your hard-earned money for the future.

We advise investors to rely 100% on a carefully crafted quantitative investment strategy, which eliminates behavioral biases and errors in judgment and offers a relaxed approach to investing that only requires us to respond to signals when they present themselves. Providing a combined 66 winning years out of 66 (100%) and an average performance that is quadruple the long-term performance of the S&P 500, the track record of our algorithmic strategies suggests that a quantitative approach to investing is tough to top.

If you have any questions or comments about this issue of ETFOptimize Insights, please contact us with a Support Ticket.


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