Skip to main content

A Smarter Way to Spot Winning Stocks

In a market where rising profits meet falling stocks, conventional strategies don't work. Here are new angles.
  • Author:
  • Publish date:

Editor's Note: Jon D. Markman writes a weekly column for CNBC on MSN Money that is republished here on

. He's also a regular contributor to



subscription site. If you'd like to see all of Jon Markman's


commentary, click here for information about a free trial.

Investing would be so easy if only it were about events that happen as expected. The problem is that most important moves in the market are unexpected, deviate from norms and cannot be counted in conventional ways.

This is always a bummer, but particularly so now, as investors try to determine whether the zippy early-November bounce is the start of an exciting new charge higher or a pointless countertrend rally doomed to fail.

The usual ways of making this determination -- via forecasts for earnings and global economic growth -- don't seem to be working right now, and new research says they never did. So rather than rely on those, we'll turn to the views of market veterans who focus simply on the demand for stocks.

First, let me explain why the old ways don't work.

Earnings Up, Stocks Down

Let's say that you knew without doubt that the economy would grow at a 3.5% annualized pace and corporate earnings would grow 16%. Wouldn't that make you bullish on equities over the next year?

Well, that's pretty much what 2005 looks like, and the market is flat. Maybe with a year-end rally, the market can end with a gain of 5% or so. But that's a far cry from the 15%-plus earnings growth rate of the nation's leading companies.

This set of facts backs the view that past and predicted earnings may not matter as much as many think. They certainly haven't so far this year for

American Express

(AXP) - Get Free Report



(IBM) - Get Free Report


Wal-Mart Stores

(WMT) - Get Free Report


Walt Disney

(DIS) - Get Free Report



(AA) - Get Free Report

. Each has reported earnings growth of 11% to 75% in the past 12 months. And analysts expect them to earn from 9.5% to 23% over the next year. Yet the shares of these five stalwart members of the

Dow Jones Industrials

are down from 9.5% to 19.8% this year.

In contrast, there are plenty of major companies -- such as


(ALO) - Get Free Report

-- that have recorded double-digit earnings declines in the past year and are expected to lose more next year, yet have seen their shares gain more than 10% in 2005.

What gives? Ned Davis Research says this disconnect between earnings and stock results has occurred because earnings don't actually drive stock results -- and never have. Quite the opposite, the Florida-based firm argued in a controversial report published late last month.

When Bad News Is Good News

The Davis research shows that in the years since 1958 in which

S&P 500

earnings growth has been greater than 6%, stocks have averaged only a 3.9% gain per year. When earnings growth has been below trend, stock returns have averaged 8.1% per annum.

Traditionalists might say, no biggie -- focus on earnings-growth expectations, not trailing growth rates. But the higher the expectations for stocks, researchers found, the worse the results.

So add this to the conventional-wisdom bonfire: Those analysts who crow about how great a stock is going to do because a company is expected to grow earnings by more than 25% next year may be all wet. The Davis study shows that the real sweet spot for stock-market returns actually occurs when a company is expected to earn 12.5% or less in the next year.

Why would this be? Davis surmises that the market does not discount fundamentals 12 months ahead, as is commonly believed. Instead, the research shows good news and optimism tend to lead to a fully invested market in which there are few bystanders left to make purchases. At the point of maximum optimism, the market basically falls over for lack of new buyers. In contrast, when news is bad and investors are feeling nervous about the future, the market is sold off -- and that puts it in position to rally.

Of course, there are important exceptions.


(NTRI) - Get Free Report

, for example, grew income 25% over the past year and is forecast to grow 80% next year; it's up 1,025% in 2005.

A Better Indicator: Inflation

There do seem to be some better clues as to future market direction. Consumer price inflation may be at the top of the list. Davis researchers report that in the 49% of the years when inflation has been clocked at greater than 3.5%, stock market returns have been subpar, at 3.9% per year. When inflation has been less than 3.5%, returns have bulled forward at a 9.8% annual pace.

Moreover, in periods like the present, when the price of food and energy is the main driver of consumer price index inflation, the Dow Jones Industrials have risen just 2.7% a year since 1958. That contrasts with 11% gains when inflation is not driven by energy and food.

The bottom line, according to the researchers, is that lower inflation, not higher earnings, may be the key to future stock returns. If the relationship holds up, therefore, investors should be less jubilant about the potential for solid returns in 2006 based simply on the prospect for continued earnings gains, and instead root for the

Federal Reserve's

efforts -- sadly ineffective, so far -- to quell the past year's surge in inflation.

Don't despair, however. Some clues suggest that even if 2006 is bound to be slow-going, the typical year-end rally may at least give you a chance to make money -- or unload your dogs at higher prices.

Bulls on Board

Investment research publisher Robert Drach, who has done a great job of advising clients to move in and out of the market at critical junctures over the past 30 years, turned bullish in late October for the first time since closing all positions in late July, noting that "increased pessimism" among the public and analysts had become supportive of the "transfer of stock from weak, nonprofessional hands ... to strong professional hands."

In an interview on Friday, he forecast that the broad market will end positive this year because of a move largely contained within the final three weeks and will post a gain in the high single digits next year after the Fed stops raising rates.

Another veteran timer, Stan Weinstein, is telling his clients that this remains "an unbelievably stock-specific tape," by which he means plenty of stocks already on the rise will "live a life of their own" and continue to improve, while the majority of others will stagnate or decline. He favors stocks in the insurance, computer software and transportation sectors, and believes investors should use strength in coming weeks to sell underperformers.

Meanwhile, cycles expert Tom McClellan, whose approach I explained in a

January column, is getting ready to put his bull on. On Friday, he said that his work suggests there will be one more bad bump in the next week or so before an impressive new year-end really gets rolling.

"We need to get where people are thinking the market is going to turn down to a lower low, and the sky is going to fall, and our teeth will all fall out just before the hurricanes and the terrorists attack simultaneously," he said. "When you start to hear that sort of sentiment in the financial media, you'll know that the consolidation is about over and the next up-leg is ready to begin."

More objectively, he notes that professional stock-index traders, known in the futures market as "commercials," have positioned themselves as bullishly as at any time in the past five years, according to the latest government-produced Commitment of Traders Report. "This is a big statement by the commercials that they still expect better things ahead for stock prices," McClellan said. "A five-day up move from Oct. 27 is not nearly enough of an answer to this call for an upward price move. There has to be more to come."

Now you knew that there had to be a party pooper in my pantheon of timers, and unfortunately it is the one who has been the most effective at calling the big moves.

Paul Desmond, editor of Lowry's Reports, is reminding clients that bull markets typically last only about three years, and this one is a month past that age now. He says history shows the bulls can lure in enough investors to rally the big indices to new highs right to the very end, giving the impression that they are alive and kicking.

But like Weinstein, he said the final surges tend to be very selective and hollow. In the past 76 years, the percentage of stocks making new highs on the top day for the major indices ranged from 2% to 11%, with the average at 6%. At the same time, he said, the percentage of stocks that were down by a fifth or more from their highs on that top day for the major price indices averaged 22%, showing that the bear market for many individual stocks had actually begun months earlier.

In summary, it seems that this is no time to pick up losers in the expectation that they will turn around. And at any rate, it is no time to be comforted solely by the expectation of improved earnings.

As originally published, this story contained an error. Please see

Corrections and Clarifications.

At the time of publication, Jon Markman did not own or control shares of companies mentioned in this column.

Jon Markman, writer of Value Investor, is the senior investment strategist and portfolio manager at Greenbook Investment Management, a division of Greenbook Financial Services. Separately, he is publisher of StockTactics Advisor, an independent weekly investment research service. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;

click here

to send him an email.

Interested in more writings from Jon Markman? Check out his newsletter, Value Investor. For more information,

click here