Warning of Better Times Ahead for Shares

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As if you really needed more evidence of the perversity of the stock market, analysts at ISI Group in New York have determined that the greater the number of negative preannouncements in the month before the end of a quarter, the better stocks tend to do at the start of the next quarter.

This insight has become especially relevant as the announcements of unexpected earnings shortfalls have been falling like a hard rain on Wall Street in the past two weeks. It's one thing when earnings-challenged basket cases such as telecom chipmaker Broadcom (BRCM) admit they've blown it again. But it's quite another when American icons such as Coca-Cola (KO) and Colgate-Palmolive (CL) come clean with shocking disappointments.

Intuitively, you would guess that a high rate of negative preannouncements would lead to declines in share values over the following month. And you would think that a low rate of negative preannouncements would tend to lead to stronger share values in the subsequent month. But you would be wrong on both counts, according to ISI's eye-opening analysis.

Earnings estimate data in June this year, according to the report, showed that the negative-to-positive preannouncement ratio for stocks in the S&P 500 was less than 1.0. That shouldn't have been considered good news. Instead, says ISI, it was a sign that most positive earnings scenarios for the quarter had been priced into equities -- and that a lousy July was around the corner. And that is what happened, as the S&P 500 sank a whopping 3.4% in the month.

Conversely, then, it may be great news that preannouncements have been so wildly awful this month. According to First Call, the negative/positive preannouncement ratio for the S&P 500 in September so far is 1.9. Analysts' earnings expectations for the coming quarter have thus become gloomy. Indeed, they're the most dreary since the third quarter of 2003. The ratio for tech stocks in the S&P 500 is a touch higher than for the broad market, at 2.0.

So the upshot is that while September may be rough from the standpoint of news, the negativity may be setting the table for improved market performance in October.

Here's a brief glance back at the recent historical record to show how this has played out before:

A very high negative-to-positive preannouncement ratio of 2.9 in March 2003 came just ahead of a one-month change in the S&P 500 of 8.1% in April 2003, according to ISI and First Call data.

A ratio of 1.7 in September 2003 preceded a 5.5% gain the next month.

The highest negative preannouncement ratio of the past five years, 6.8 in March 2001, preceded a 7.7% gain in April 2001.

Likewise, a 5.3 ratio in June 1997 preceded a 7.8% July that year.

Conversely, a quiescent preannouncement ratio of 1.0 in March 2000 preceded a 3.1% decline in April that year.

And a modest 1.0 ratio in June 2002 preceded a 7.9% plunge in July that year.

A reasonable interpretation of ISI's study is that the market is highly effective at pricing in (and anticipating) bad news. So, to take this concept a little further, I ran a screen to discover the S&P 500 stocks for which analysts have the lowest expectations over the next year. If the ISI theory is right, high levels of negativity among investment professionals might lead to outperformance for these stocks in the next month as the bogeymen turn out to be not quite so scary as feared.

S&P 500 Stocks With Negative Analyst Growth Expectations
Company Name	Symbol	Next Yr % Est. Growth	Current Qtr. % Est. Growth	StockScouter Rating	Last Price
Winn-Dixie Stores	WIN	-320	-700	4	$3.80
LSI Logic	LSI	-6.8	-221.4	5	$4.38
AT&T	T	-78.7	-87.2	8	$15.49
Dynegy	DYN	-2187.5	-48	10	$4.57
Countrywide Financial	CFC	-2.7	-44.9	7	$37.30
Lehman Brothers Holdings	LEH	-3.6	-14.6	9	$76.02
Bear Stearns	BSC	-7	-14.6	8	$87.74
Bristol-Myers Squibb	BMY	-12.5	-13.5	6	$24.24
BellSouth	BLS	-15.1	-4.7	8	$27.71
Source: MSN Money

Of these stocks, it's interesting to note that widely hated Dynegy (DYN), AT&T (T) and Bristol-Myers Squibb (BMY) have all been trading up in the past couple of weeks in opposition to consensus earnings expectations. Dynegy, the utility noted for its decision to back out of a merger with Enron in that benighted company's waning days, in fact appeared to break out of an eight-month trading range on Monday with a 9-cent advance.

I'll keep track of these stocks, and the fate of the negative preannouncement ratio, as October unfolds.

At the time of publication, Markman was long Dynegy, although positions may change at any time.

Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment research service, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. He also writes a weekly column for CNBC on MSN Money. While Markman cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at [e-mail]