How to Play Decelerating Earnings Growth Going Into 2012

I laid out a road map for the end of the year a few weeks back, before the market took off.

It went something like this: Expect a strong upward move following the recession forecast by the Economic Cycle Research Institute that would end at around the 10-month moving average of the S&P 500, around the 1,280 area.

After that, I suggested the market would stall, and then keel over, as the prospect of recession became more evident.

I expected this to play out over two or three months, with the top hitting around the end of December, but it seems that lately the market likes to rush from one place to another. In August, stocks rushed to a low, and in October stocks rushed to a high. Everyone is in a hurry these days.

What�s fascinating about the move higher in October was that returns shunned many conventions. Normally, at a time like September when you are looking at what to own after two tough months, you are considering stocks that have weathered the recent storms the best — and that would have been staples and utilities.

Yet as it turned out, the stocks that turned out best in October, during the rebound, were ones that had been crushed the most in the previous two months.

In this way, the rally turned out just like the autumn-winter rally in 2010: Beaten-down energy, materials, financial and industrial stocks performed best, as well as the more cyclical subsectors of technology. Some notable names were F5 Networks (NASDAQ:FFIV), Credit Suisse (NYSE:CS) and Arch Coal (NYSE:ACI).

This rebound occurred during an earnings season whose details were obscured from day to day by the flash of a lot of news out of Europe. The noise from the old country was so overwhelming that it was easy to miss something really important that was happening as U.S. companies reported.

Mike Wilson at Citigroup (NYSE:C) points out that in contrast to last year at this time, earnings growth is now rapidly decelerating from previously high levels. That is a huge change from last year, when earnings growth was exploding higher.

This is a little hard to see on the surface because the level of growth is around the same — at around 15% year-over-year on average. The difference is the rate of change, and Wilson points out, quite correctly, that for stock pricing it�s always the trajectory of growth, rather than the absolute level, that matters the most.

Wilson�s unique model suggests that this deceleration is not about to stabilize, and in fact points to “meaningfully negative” earnings growth in 2012. That does not mean all companies� earnings will contract, but it does mean it will take a lot of skill to pick stocks rather than sectors.

The most obvious ways to see this already are in the two major earnings misses of the season: Amazon (NASDAQ:AMZN) and Apple (NASDAQ:AAPL). These two former earnings growth leaders are no longer leading. It’s the same with industrial giants 3M (NYSE:MMM) and Schlumberger (NYSE:SLB).

If this trend continues, potentially the best way to play stocks going forward is to buy ones in which earnings expectations are already in the dumps, and short ones for whom expectations are highest.

I think that this is why FFIV worked out so well: All along, I had said expectations were too low, and so when it reported and results were OK, it was as if it was reporting 100% growth.

Right now, the areas where expectations are lowest — according to Wilson and confirmed by my own research — are financials, autos and semiconductors. Expectations are highest in staples, software, IT services and high-end consumer.

Topping Off

Now, my discussion is going to get a little more esoteric about the potential for decline from here, but bear with me because there is a good payoff. Again, I am leveraging a combination of my own work as well as the research of Wilson.

Since 1929, the Citigroup analyst reports, there have only been 19 occurrences in which the 200-day moving average of the S&P 500 has trended down for 50 consecutive days, with the “trend” defined as the rolling 10-day average. On the last Wednesday in October, this happened for the 20th time.

What�s interesting is that the pattern has a distinctive routine before and after. What tends to happen before is a rapid 20% correction that doesn�t bounce much, thus causing this unique negative trend. After approximately 100 days from the peak, the market then tends to stage a sharp rally that comes within 5% of the downward-sloping 200-day average.

On average, this rally lasts approximately 50 days and marginally surpasses the 200-day average. Then, the rally fails and proceeds to drop approximately 20% to 25% over the next six months. The final low is 32% below the original peak, an amplitude that implies the S&P 500 will hit 950 by April 2012.

While this approach differs from the approach that I provided in my road map, it reaches much the same conclusion. Price patterns certainly can diverge from the precedent, but Wilson points out this setup has only occurred 20 times in the past 90 years — and 95% of the time, the first big rally fails right around the 200-day; just like the recent rally did.

It�s going to be very tempting to shift entirely to the short side of the market armed with this information, but considering that there still are a lot of levers that political and central bank leaders can pull, we would want to tread carefully at first.

Bottom line: We need to be careful not to be sucked into the siren call of the long side just because the market is up over the past month. Nothing has been solved in Europe, earnings growth at major companies is decelerating here, and a global recession still looks to be in the cards.