Denise Chisholm, director of quantitative market strategy, is a market strategist in the Quantitative Research and Investments (QRI) division at Fidelity Investments. Chisholm explores a bullish take on earnings declines by looking at market data through a historian's lens. She believes historical patterns, when considered in the appropriate context, can help investors build conviction about future trends.
- Historically, weak earnings and investor fears corresponded with strong subsequent returns, especially among cyclicals and small caps.
- After poor earnings, cyclical sectors typically led.
- High small cap valuation spreads suggest investor fear.
- Cheapness relative to large caps typically positions small caps to outperform.
- Quantitative analysis suggests a bullish investment view.
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).
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.
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 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, 2023.
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.
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: Haver Analytics and Fidelity Investments, as of April 30, 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.
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.