Economics discovers the concept "Enough"

If Profits Grow, How Can the Market Sink?
By MARK HULBERT

Published: February 6, 2005

...The reason that the overall market usually fails to react more favorably to rapidly rising earnings is not that earnings growth is bearish itself. The problem, the professors say, is that such growth usually leads to higher interest rates. When rates rise, the net present value of future earnings, cash flow and dividends automatically falls, and this generally causes the market to decline.

The professors say the Federal Reserve is unlikely to feel pressure to raise rates when just one company reports better-than-expected earnings. So the company's profit growth can be expected to translate into a higher stock price. But the Fed will certainly feel that pressure when aggregate market earnings rise quickly.

To be sure, the professors' findings are based on a long-term average, and exceptions are inevitable. One occurred in the last couple of years, when earnings grew at a double-digit rate and the overall market performed well, too. But Professor Lewellen says that this recent experience is "the exception that proves the rule," because the Fed kept interest rates artificially low over much of this period. That prevented the fast growth of marketwide earnings from having usual negative consequences.

The powerful role of interest rates in the stock market's valuation also explains why the market tends to perform best when aggregate corporate earnings are falling. Ned Davis Research says that since 1927, the Standard & Poor's 500-stock index has risen at a 28 percent annualized rate - nearly triple its historical average - during quarters in which earnings were 10 to 25 percent lower than where they were in the periods a year earlier.

This bullish effect vanishes, however, when earnings are falling too much. Ned Davis Research found that during those few quarters since 1927 when earnings were more than 25 percent below their year-earlier levels, the S.& P. 500 declined at a rate of 28 percent, annualized. Professor Lewellen says that this is consistent with the results of his research. "The positive effects of lower interest rates, though strong enough to overcome the negative consequences of more modest declines," he said, "are unable to overcome them when earnings are falling by a huge amount."

Posted by Prometheus 6 on February 6, 2005 - 6:31am :: Economics
 
 

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