A Bullish Take on Earnings Declines
Earnings have declined for more than a year, a setup that has been bullish in the past.
Commentary
Earnings Declines Indicated Opportunity, Historically
The COVID-19-era profit recovery ended more than a year ago: Aggregate earnings
among S&P 500 companies fell over the three- and 12-month periods through March,
putting year-over-year earnings growth in the bottom quartile of its range since the
early 1960s. Historically, earnings downturns have signaled opportunity for investors.
Since 1962, the S&P 500 has had an 11% average return during the 12 months after
bottom-quartile last-12-month earnings growth—higher than the index’s average returns
following all other earnings-growth quartiles (Exhibit 1).
A Bullish Take on Earnings Declines
Earnings have declined for more than a year, a setup that
has been bullish in the past.
Denise Chisholm
Director of Quantitative
Market Strategy
I approach my research by looking at market data through a historian’s
lens. I believe historical patterns, when considered in the appropriate
context, can help investors build conviction about future trends. This
month, I’m focusing on the fact that in the past, weak earnings and
investor fears corresponded with strong subsequent returns, especially
among cyclicals and small caps.
EXHIBIT
1: Stocks Had Stronger Returns after Weaker Earnings Growth
Quarterly NTM Average S&P 500 Returns in Quartiles of LTM EPS Growth, 1962–Present
Past performance is no guarantee of future results
. NTM: Next twelve months. LTM: Last twelve months. EPS: Earnings
per share. Analysis based on the S&P 500. All data gathered and analyzed quarterly from 1962 to March 2023. Sources:
Haver Analytics and Fidelity Investments, as of March 31, 2023.
Worst Quartile (EPS
Growth of -77% to -2%)
Quartile 2 (EPS
Growth of -1% to 10%)
Quartile 3 (EPS
Growth of 11% to 18%)
11%
8%
7%
7%
Best Quartile (EPS
Growth of 19% to 110%)
0%
2%
4%
6%
8%
10%
12%
A Bullish Take on Earnings Declines
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2
EXHIBIT
2: Cyclicals Had Better Odds after Weak Earnings
Quarterly NTM Historical Odds of Outperformance Post
Bottom-Quartile LTM EPS Growth, 1962-Present
Past performance is no guarantee of future results.
NTM: Next twelve
months. LTM: Last twelve months. EPS: Earnings per share. Cyclical sectors
include communication services, consumer discretionary (CND), energy,
financials, industrials, materials, real estate, and technology. Defensive sectors
include consumer staples, health care, and utilities (UTL). Analysis based on
the S&P 500. All data gathered and analyzed quarterly from 1962 to March
2023. Sources: Haver Analytics and Fidelity Investments, as of March 31,
Earnings could weaken further, but that may not drag
down stocks: After earnings downturns, the stock
market historically started recovering two to three
quarters before earnings did, on average.
After Poor Earnings, Cyclicals Typically Led
Cyclical sectors tended to outperform for the 12
months following bottom-quartile 12-month earnings
growth, beating the market 57% of the time, compared
with 41% for defensives. Within cyclicals, consumer
discretionary stood out, outperforming the market
more than two-thirds of the time in the 12 months
following bottom-quartile year-over-year earnings
growth (Exhibit 2).
EXHIBIT
3: High Small Cap Valuation Spreads Suggest
Investor Fear
Russell 2000 Book Yield Spread
Past performance is no guarantee of future results.
Book yield: The ratio of
book value per share to price per share. Book yield spread: The difference
between the average book yields of the Russell 2000’s most-expensive and
least-expensive quartiles. The Y axis represents a weighted differential
between the two quartiles. Analysis based on the Russell 2000. All data
gathered and analyzed monthly December 1990 to April 2023. Sources:
The Small Cap Market Looks Scared
Valuation spreads—the difference in valuation
between the cheapest and most expensive groups
of stocks—have been a gauge of investor fear.
Within small caps, valuation spreads based on
book yields were at historical extremes at the end
of April, reaching the widest 5% of their range since
1990 (Exhibit 3). Historically, these levels signaled
opportunity. Since 1990, when book yield spreads in
the small cap Russell 2000 Index reached their top 5%,
the index posted a 46% average return over the next
12 months.
CND
Cyclical
Sectors
Defensive
Sectors
UTL
0%
40%
80%
69%
57%
41%
34%
30
50
90
70
130
110
150
170
‘90 ‘92 ‘94 ‘96 ‘98 ‘00 ‘02 ‘04 ‘06 ‘08 ‘10 ‘12
‘22
‘14 ‘16 ‘18 ‘20
A Bullish Take on Earnings Declines
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3
EXHIBIT
4: Small Caps Outperformed after Cheap Relative Valuations
Historical Odds of Russell 2000 Outperforming S&P 500 over NTM from Various Relative Book
Yield Tranches, 1990–Present
Past performance is no guarantee of future results.
NTM: Next twelve months. Book yield: The ratio of book value per
share to price per share. Analysis based on the S&P 500 and Russell 2000. The Y axis represents the historical odds
of each tranche of the Russell 2000 on the X axis outperforming the S&P 500 index over the NTM. All data gathered
and analyzed monthly from December 1990 to March 2023. Sources: Haver Analytics and Fidelity Investments, as of
March 31, 2023.
Cheapness Relative to Large Caps Positioned Small Caps to
Outperform
Small caps looked unusually inexpensive relative to large caps as of the end of April,
based on book yield. Since 1990, the only time small caps were cheaper compared
with large caps was in the early days of the pandemic. Historically, the cheaper the
Russell 2000 was relative to the S&P 500 on book yield, the more likely the small cap
index was to outperform its large-cap cousin over the next 12 months (Exhibit 4).
This analysis, in addition to my other recent research, gives me a positive outlook for
stocks—especially cyclical sectors and small caps.
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
100%
78%
53%
28%
74%
44%
24%
Bottom Decile
—Expensive
Q1
Q2
Q3
Q4
Top Decile—
Cheap
Top 5% —
Cheap
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S&P 500 index
is a market capitalization-weighted index of 500 common stocks chosen for
market size, liquidity, and industry group representation to represent U.S. equity performance.
Russell 2000 Index
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Author
Denise Chisholm
Director of Quantitative Market Strategy
Denise Chisholm is a market strategist in the
Quantitative Research and Investments (QRI)
division at Fidelity Investments. In this role, she
is focused on historical analysis, its application
in diversified portfolio strategies, and ways
to combine investment building blocks, such
as factors, sectors, and themes. In addition to
her research responsibilities, Ms. Chisholm is
a popular contributor at various Fidelity client
forums, is a LinkedIn 2020 Top Voice, and
frequently appears in the media.
Prior to assuming her current responsibilities in
September 2020, Ms. Chisholm held multiple
roles within Fidelity, including sector strategist,
research analyst on the Megacap Research team,
research analyst on the International team, and
sector specialist.
Fidelity Thought Leadership Vice President Mike
Tarsala provided editorial direction for this article.
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