It sure doesn’t look like the makings of a bear market. Corporate earnings are still growing at a double-digit rate, unemployment is low, consumers are still spending heavily. Yet the stock market in 2005 stubbornly refused to reflect these conditions, with stock appreciation more than ten percentage points below earnings growth, and total returns for last year not much above those on medium-term bonds. There should be plenty of room to catch up in 2006, right?

Unfortunately, after the strong start, the second quarter is beginning to feel a bit iffy, with worries about interest rates, oil prices, and global political tensions. What’s more, mid-term elections loom ahead. Will the bulls finally be vindicated this year? Or is it possible that the bears could be right and the market averages fall in 2006?

Averages Don’t Tell the Whole Story

Bulls feel that in almost any given year, there is the potential for double-digit percentage earnings gains. And they’d be right, because earnings (on the Dow or the S&P 500) have in fact risen at such rates more years than not since the early 1920s. Bears point out that hopes for a double-digit growth trajectory and corresponding gains in stocks are optimistic—because the average annual rate of earnings growth over the whole span has been only 5.5%. And they’d be right, also. Results last year had fodder for both bulls and bears: Corporate earnings growth was in the low teens, but the S&P was up only 3% in price terms (almost 5% counting dividends). So how can both the bulls and bears be right?

Downturns Tell the Tale

The reason for this paradox lies in the fact that corporate earnings take a major tumble, of roughly 20%, every few years, thereby depressing average annual earnings growth. Suppose earnings went up at X% a year for four out of five years, and then fell 20% in year five, how high would X have to be to maintain the average growth rate at 5.50% a year for all five years? The answer, given at the end of this article, is surprisingly high.

Although earnings sometimes fall 20% in one year, stocks rarely decline that much, (and the rare exceptions to this rule take place when there are two down earnings years close together, in either a prolonged single, or an intermittent double dip recession). Otherwise, stocks are not as volatile as earnings on either the upside or downside, which is why single-digit stock market gains are more common than single-digit earnings growth.

Under these circumstances, it’s less important to quantify how good a good year will be than to anticipate the occasional bad year, which has a far greater impact on returns. Thus, it doesn’t much matter whether corporate earnings growth in 2006 will be in the high single or low double digits. It’s much more important to forecast whether or not there will be a decline in 2007, an possibility that would pose by far the greater danger to investors than any softness in 2006.

To further complicate the issue, the stock market cycle may not track the earnings cycle, but rather lead or lag it by one year or more. Thus, earnings and GDP growth in 2006 could be fine, living up to the fondest expectations of the bulls, but stocks could fall later this year if it looks like a downturn is looming in 2007. The reverse has also happened. Stocks continued to drop almost a full year after the 2001 earnings decline because of unwarranted fears of a further fall in 2002.

Why I Am A Bear Just Now

The last time that corporate earnings took such a tumble (down 17%) was in 2001. If it happened every five years, we’d be looking at a similar event right about now. But it probably won’t occur this year. It could have happened in 2004 or 2005, but didn’t. It can also happen in 2007 or 2008. The suspects are the usual ones: High oil prices, low savings rates, and the adjustment of ARMs starting this year and next in a rising interest rate environment will finally bring a halt to consumer spending, a recession, and a drop in corporate earnings. So, too, could a popping of the investment bubble in China and elsewhere in Asia.

Bulls may say that these potential problems don’t matter. A recession hasn’t already happened and therefore won’t happen. But this observation isn’t valid, because it’s the last nail that seals the coffin. I’m a bear because I believe it will happen soon (in calendar 2007 with the U.S. stock market reflecting this in late 2006). It’s optimistic to assume that a recession won’t happen until 2010, which would trigger a market anticipation in 2009.

The X Factor

X, in the above paradox, was just over 13% (13.06% to be more exact). Yes, there can be low teens earnings growth for four years out of five. But the bad fifth year really hurts overall returns.

Get the Balance Right

Bulls react strongly to positive reinforcement, because they’re right more often than not, but they sometimes underestimate the impact that the occasional bad year can have on the averages. Bears, on the other hand, have a more realistic sense of the long-term averages, but sometimes overlook the fact that the market environment is actually favorable most of the time, even in secular bear markets (when stocks go up slightly more than 50% of the time, rather than almost all the time, as is the case in bull markets). Finding a good balance between optimism and pessimism is key to investment success.

© 2006 Thomas P. Au
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