In the article it is shown that year-to-year change of the S&P 500 does not depend on profits cycle. On the other hand, year-to-year change of earnings multiple P/E tends to anticorrelate with profits cycle. It shows sluggishness of market response in relation to profits cycle. It is shown that there is one important condition for development of new long-term bull trend. It is presence of phase of earnings accumulation. Such accumulation is possible only during periods of significant outstripping of earnings growth over the market growth. Now there is no phase of earnings accumulation, because market returned to 8% long-term growth rate, which outstrips the 5.5% long-term earnings growth rate. Such conditions can support only sideways market at best.Profits cycle, earnings, growth rate, P/E ratio, earnings accumulation, Fed's model, CRB Spot Index, 10-Y Treasury bond yield

Dmitry Baryshevsky

English

Research Papers in Economics

Playing on profits cycle?
Dmitry Baryshevsky
e-mail: dmitry_baryshevsky@yahoo.com
Abstract
In the article it is shown that year-to-year change of the S&P 500 does not depend on
profits cycle. On the other hand, year-to-year change of earnings multiple P/E tends to
anticorrelate with profits cycle. It shows sluggishness of market response in relation to profits
cycle. It is shown that there is one important condition for development of new long-term bull
trend. It is presence of phase of earnings accumulation. Such accumulation is possible only during
periods of significant outstripping of earnings growth over the market growth. Now there is no
phase of earnings accumulation, because market returned to 8% long-term growth rate, which
outstrips the 5.5% long-term earnings growth rate. Such conditions can support only sideways
market at best.
1.  Introduction
Statements that the renewed earnings growth must be very favorably reflected in stock's
prices sound frequently now. So, according to Standard & Poor's data for the second quarter of
2003 the trailing four-quarter earnings has grown more than 30% in comparison with the second
quarter of 2002. Such data look very impressive and create comfortable feelings among market
participants. Really, if the earnings growth looks so good why market should not grow? At the
first glance investor's investment decision should be very simple to buy stock while earnings is
growing.
Nevertheless, it is necessary to remember that market is a complex system. Short-term
year-to-year earnings growth (profits cycle) is only one of system parameters. In order to
understand the performance of a complex system it is necessary to use a few of key factors. So,
for example in [1] the importance of dynamics of the commodities' prices (CRB Spot Index) for
all financial market is shown.
However, earnings growth is one of the most frequently used expressions by both
financial analysts and market practitioners.
In order to operate correctly with concepts "long-term earnings growth" and "short-term
earnings growth" (or profits cycle) it is important to understand influence of each of the specified
parameters on dynamics of market prices.
2.  Discussion
In Figure 1 profits cycle (year-to-year percent change in trailing four-quarter earnings)
since March 1950 till March 2003 is shown.
I have checked up whether there is any correlation between year-to-year change of the
earnings and respective change of the S&P 500. Analysis was done for the period since March
1872 till July 2002.
The following procedure was used for analysis. The year-to-year change of the earnings
and the year-to-year change of S&P 500 for the same quarters were compared. The statisticalprocessing of a data set for the chosen historical period was carried out. I found that the
correlation coefficient R-squared between one-year change in S&P 500 and the similar change in
trailing four-quarter earnings is only 6%.  In other words, one-year change in trailing four-quarter
earnings can predict only about 6% of the variability of the S&P 500’s four-quarter returns.
There were compared the year-to-year change of the earnings for the certain quarter and
year-to-year change of S&P 500 for the next quarter. The above procedure was done not only for
the next quarter but also for one-quarter shift, two-quarter shift and in four-quarter shift. I found
that values of correlation coefficients R-squared are less than 1% in these cases.
The received results testify that year-to-year change of the S&P 500 does not depend on
profits cycle (i.e. year-to-year change in trailing four-quarter earnings). Therefore, for example,
during the period of cyclical earnings growth the market can move both upwards and downwards.
What parameters of the market can correlate with profits cycle? In Figure 2 the dynamics of
profits cycle and 1-year P/E change is shown.
It was shown that correlation coefficient R-squared between year-to-year P/E change and the
profits cycle is equal to 38.9 % (adj. R-squared 38.8 %) for the period since March 1872 till July
2002. Correlation coefficient appears negative (see Table 1)
Table 1
Regression Summary for Dependent Variable:
1 year P/E change
R= -0.62 R-sq = 0.389 Adj R-sq = 0.388
F(1,518)=329.51 p<0.0000 Std. Error of estimate: 20.138
St. Err. St. Err.
BETA of BETA B of B t(518)
Intercept 7.86 0.910 8.64
1 year earnings
change
-0.62 0.034 -0.72 0.040 -18.15
The similar analysis was carried out for the period since March 1950 till March 2003. It showed
that correlation coefficient R-squared appeared 52.8 % (adj. R-squared 52.6 %), Table 2 and
Figure 3.
Table 2
Regression Summary for Dependent Variable:
 1 year P/E change
R= -0.7266 R-sq = .528 Adj R-sq = .526
F(1,211)=236.02 p<.00000 Std. Error of estimate: 15.47
St. Err. St. Err.
BETA of BETA B of B t(211)
Intercept 11.692 1.137 10.28
1 year earnings
change
-0.7266 0.0472975 -1.057 0.069 -15.36
So, on the one hand year-to-year change of S&P 500 does not correlate with profits cycle.
On the other hand year-to-year growth of earnings multiple P/E (one-year earnings multiple
cycle) corresponds to negative profits cycle and vice versa.
These relations show sluggishness of market response in relation to profits cycle.In Figure 4 the dynamics of P/E ratio (right scale) and S&P 500 profits cycle (left scale)
are shown. Existence of long-term cycles of P/E was shown in [2]. From Figure 4 it can be seen
that short-term cycles concerned with profits cycle also exist.
In accordance with analysts estimates from Thomson First Call the peak earnings growth
of 61% is expected for the fourth quarter of 2003 [3].
What should be expected from the market thereupon?
For the last 60 years the most impressing positive profits cycle was observed since
December 1946 till December 1949. In Figure 5 profits cycle (left scale) and nominal profits
(right scale) are shown. Since June 1946 till June 1949 earnings grew on 186% (from 0.84 up to
2.4). The bottom point of previous negative profits cycle was as the start point of calculation.
During two periods (see Figure 5) earnings growth exceeded 70%. At the same time (from June
1946 till June 1949) S&P 500 fell on 25 % (from 18.58 up to 13.97). As a result of so rash
earnings growth and simultaneous fall of the market the P/E ratio was lowered from 22.12 (June
1946) up to 5.8 (June 1949). Thus, the positive profits cycle of the end of 40-th resulted in
accumulation of the significant earnings by the market. Later such accumulation of earnings
allowed developing the bull trends for both the earnings multiple and the equity market, which
were prolonged to the beginning and end of 60s, respectively. In Figure 6 the dynamics of
S&P 500, nominal earnings (left scale) and P/E ratio (right scale) are shown.
Next accumulation phase was in 70s when the market moved sideways. Since December
1970 till March 1980 earnings grew about three times (from 5.13 up to 15.29), see Figure 6.
During this period P/E ratio was lowered from 17.55 up to 6.85.
It is necessary to note [2], that since 1872 up to 2002 the nominal earnings and dividend
growth rate followed 1.5% per year growth curve. The market also grew in accordance with 1.5%
per year growth curve. But the long-term earnings growth was accelerated in the second half of
20-th century and earnings followed 5.5 % per year growth curve since 1949 (see Figure 7).
The latest positive profits cycle began in September 2002. Earnings bottomed at the 24.7
level in December 2001. By estimations of Standard & Poor's, earnings run up to 44 by the end of
the year, i.e. by 78 % in comparison with December 2001. As it is shown in Figure 7 now the
earnings simply come back to 5.5 % long-term growth rate. By the end of 2003 meanings of
earnings correspond to 5.5 % long-term growth rate should be equal to 42. At the same time, S&P
500 has returned to the 8% long-term growth rate (see Figure 8). As the consequence the
divergence of earnings growth rate and market growth rate is still intact.
If S&P 500 is about 1000 and meaning of earnings is equal to 42 then the P/E ratio is
23.8. This value of P/E ratio does not look attractive from historical perspective.
Therefore now one should not talk about accumulation of earnings (it should be reflected
in essential reduction of P/E value), Figure 9.
Such conditions can result in two scenarios.
First scenario supposes that market stays in sideways movement for years. In this case
market would be waiting while it could accumulate essential earnings (like in 70s). According to
[4] in conditions of low inflation and low interest rates in the absence of war the earnings
multiple P/E can stay at the high level. It means that inertial nature of a human would hold him in
opinion that favorable environment could last out for a long time. Really, at the end of 40s and
during the 70s the inflation was higher than now. The 3-year CPI variability (see Figure 10, right
scale) was more then 7% at the end of 40s and approximately 2.5% during the 70s.  But it is
necessary to note that the 3-year earnings variability (left scale) reaches now the high level
observed only at the end of 40s, while inflation and interest rates are low now and there is no war.
To calculate variability one should compare the meanings of trailing earnings and CPI for the
required quarter with the appropriate meanings of the same quarter for the previous year. Then
values for 12 quarters (or 3 years) are gathered and standard deviation for this set is calculated.
So low inflation and low interest rates cannot provide adequate stability.Moreover, the stock market does not exist independently. In [1] the model of the
alternative investments is offered. This model establishes correlation between current real
earnings yield (reciprocal of the P/E ratio)(CREY), 10-Y Treasury bond yield (TBY) and 10-year
average for CRB Index yield (CRBY) (where CRB Index yield is the one-year change in the price
of CRB Spot Index) in the following way:
( ) 4.19 0.72 0.54 p CREY pred TBY CRBY  ,
p CRBY CRBY TBY 
As of October 17 the yield of 10-Y Treasury bond was 4.39%, the meanings of 10-year
average for CRB Index yield was 1.02%. So, the prediction for CREY is 5.53%. It means that
corresponding P/E ratio should be equal to18.1.
Thus even in relative stable conditions the stock market's yield should be higher in order
to compete with the yields of alternative investments.
Second scenario supposes that some shock could result in fast fall of equity prices.
3.  Conclusion
It was shown that there is no correlation between the year-to-year change of S&P 500 and
profits cycle or "short term earnings growth". But one-year earnings multiple cycle tends to
anticorrelate with profits cycle. This indicates sluggishness of market behavior with respect to
profits cycle. In long-term outlook market prices have tendency to move along with the long-term
earnings growth. The rise of long-term bull trend is possible only if during the periods of
significant earnings growth market falls or moves sideways. The above-mentioned conditions
must lead to the essential reduction of P/E ratio. So the earnings accumulation at the end of the
40s and during the 70s create basis for development of the following long-term bull trends for
both the earnings multiple P/E and the stock market. Present situation indicates that market has
returned to the 8% long-term growth rate, which outstrips the 5.5% long-term earnings growth
rate. Therefore, we cannot speak about phase of earnings accumulation now. Such conditions can
at best support only sideways market.
References:
[1] "What is hidden in the Fed's model? The second approximation", Dmitry Baryshevsky, Gold -
Eagle, August 21, 2003, www.gold-eagle.com/editorials_03/baryshevsky082103.html,
Social Science Research Network, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=439700
[2] "The speed", Dmitry Baryshevsky, Gold - Eagle, July 17, 2003,
 www.gold-agle.com/editorials_03/baryshevsky071703.html
[3] "Global Research Highlights", Richard Bernstein, August 22, 2003, Merrill Lynch
[4] "Staying The Course With High b1: ‘Gather Ye Rosebuds While Ye May’", Edward Keon and
others, Quantitative Equity Strategy, September 24, 2002, Prudential FinancialFigure 1
-60.0%
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1 Year Earnings Change
Figure 2
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1 Year Earnings Change 1 Year P/E ChangeFigure 4
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0.1
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Figure 6
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S&P 500 Earnings P/E
186% Earnings
 growth
Three times
 Earnings grow th
"Bear" trend
 in S&P 500
Sidw ay movment
in S&P 500Figure 7
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EPS 4.7% EPS Grow th 6.2% EPS Growth
3% EPS Growth 5.5% EPS Grow th
42
Earnings returns
to 5.5% long-term
growth rate 
Figure 8
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S&P 500 6.3% S&P 500 Growth 8% S&P 500 Growth
S&P 500 has returned to the 
8% long-term grow th rateFigure 9
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0.00
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S&P 500 Earnings P/E
Sidway movment
 in S&P 500
Three times
 Earnings growth
The extremely 
high valuation 
pointed out that  
there is no 
accumulation 
phase
Projected P/E ratio 
by the end of 
2003 
corresponded to 
5.5% long-term 
growth rate 
24
Figure 10
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0%
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3 Year Earnings Variability 3 Year CPI Variability

Playing on profits cycle?

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Playing on profits cycle?

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