Can stocks continue to rise as earnings fall?

Associated Press Published: October 7, 2012
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U.S. economic growth has slowed to an annual rate of 1.3 percent, practically stall speed. Meanwhile, the old formula that companies have used to compensate — pulling more profit out of each sale by trying to run leaner — suddenly isn't working.

You can only cut expenses and squeeze workers so much, and many companies seem to have reached the limit. Profit margins are falling for the first time in the recovery, after hitting a record of nearly 9 percent, according to Goldman Sachs.

The other way U.S. companies have posted higher profits is by selling more abroad. But many of the 17 countries that use the euro have fallen into recession. And developing countries are facing headwinds now, too. China, India and Brazil are slowing. On Wednesday, the Asian Development Bank slashed its growth forecast for emerging economies this year and next.

So what's kept stocks rising? One theory is loose monetary policy.

The Federal Reserve announced last month a third round of bond-buying to try to stimulate the economy. That followed a bold plan by the European Central Bank to buy government bonds of struggling countries in its region.

"Central banks have single-handedly kept asset prices elevated," said Peter Boockvar, equity strategist at trading firm Miller Tabak Advisors. "It's certainly not the economy. It's certainly not the trajectory of earnings."

To be sure, analysts have been too pessimistic before, and investors who ignored them made money. Analysts expected earnings to fall in the first quarter of 2012, but they didn't. Those who bought the S&P 500 at the start of the year are up 16 percent.

And even if analysts are right and earnings fall, you can still make money buying stocks, though history suggests it's risky.

In the 46 quarters since the start of 2001, earnings for the S&P 500 have fallen 15 times. Seven of those times, stock prices rose the following three months, sometimes spectacularly.

In the first quarter of 2009, S&P 500 earnings plunged 35 percent. Yet investors who were brave enough to buy stocks enjoyed an S&P 500 gain of 15 percent over the next three months. If they held on after that, they doubled their money.

Similarly, investors won big who bought after the third quarter of 2001, when earnings fell 23 percent. Stocks rose 10 percent the following three months. But unlike in 2009, the next few quarters produced losses as earnings kept plunging. Stocks dropped for the next three quarters, in one of them by 18 percent.

Investors shrugging off disappointing earnings now are hoping the current period resembles 2009. But it's not a sure bet, and they may end up getting something closer to 2001 instead.