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Trading Earnings Through the Rearview Mirror

“In the business world, the rearview mirror is always clearer than the windshield.” – Warren Buffett

Legend states unequivocally that “earnings drive stock prices.” The implication: higher earnings portend higher stock prices and lower earnings just the opposite. If earnings are lower than last year, you sell. If earnings are higher, you buy. Simple and intuitive.

Period, end of story?

Not exactly.

Going back to 1871, if one had followed such a timing strategy in the U.S. stock market, the results would have been nothing short of disastrous. A $10,000 investment in the S&P 500 would have grown to over $2.2 billion during this period versus only $15 million for the earnings timing strategy (ignoring transaction costs/slippage/taxes etc.).

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Note: Data is total return, from Robert Shiller.

This equates to an annualized return of 8.9% for the S&P 500 versus 5.2% for the earnings timing strategy. I refer to this stark differential in performance (3.7% annualized) as the “Rearview Mirror Gap,” the price investors pay for timing their exposure to stocks based on backward-looking earnings data.

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That’s not to say that earnings growth is unimportant to long-term returns. It is indeed very important that earnings go up over time. But that importance is on an entirely different time frame and not necessarily tradeable information.

By the time earnings data is released on the prior quarter, the market is already looking ahead to the future. When the future stops looking like the prior quarter, problems arise when using earnings to time your exposure to stocks. Specifically, when earnings have been negative (a sell signal) but turn positive, investors often miss out on gains. They also miss out when earnings go down but stock prices continue to rise (yes, this can happen as we have seen over the past year and a half).

Over time, missing out on those gains seems to exceed any benefit of avoiding some of the market losses when earnings and stock prices continue to decline after a period negative earnings. This includes periods like 2008 when selling on bad year-over-year earnings would have worked well for a few quarters.

The problem is that there aren’t enough of these recessionary periods like 2008, and more often by the time you are selling based on bad year-over-year earnings, stocks are already down and more likely to rebound going forward. And by the time year-over-year earnings turn positive again, stocks have already moved considerably higher.

If earnings are not a leading indicator, why do we focus on them so much?

The same reason why we focus so intensely on the jobs report, another lagging indicator. Earnings lend themselves well to storytelling, at the macro level about the broader market/economy and at the micro level about companies themselves. We all love a good story, so earnings information will always be front in center in the market news flow.

In recent quarters, the story on earnings has not been a particularly good one. S&P 500 earnings have declined on a year-over-year basis for six consecutive quarters, the longest downward spiral since the 2007-09 recession.

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If one were following earnings, they would have sold out of the market back in early 2015. As the S&P 500 is now at all-time highs, this has confounded many as it seems to go against the notion that earnings and stock prices are inexorably tied at the hip.

Indeed, but as we know from history, this is not the case. Stocks can go up in the face of negative earnings. The resiliency of the market today likely tells you market participants are looking ahead to higher earnings to come, and we are already seeing signs of that this quarter.

The lesson for investors is clear. Earnings only tell you what has happened, not what will happen. Investing, of course, is all about what will happen. On the road to investment success, spend more time focusing on the dirty windshield than the clear rearview mirror.

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Related Posts:

Lower Earnings, Higher Stock Prices: The Voting Machine

The Earnings Enigma

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie-Bilello

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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