A smarter way to spot winning stocks

By Jon Markman

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, news, msgs), IBM (IBM, news, msgs), Wal-Mart Stores (WMT, news, msgs), Walt Disney (DIS, news, msgs) and Alcoa (AA, news, msgs). 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 ($INDU, news, msgs) are down from 9.5% to 19.8% this year.

In contrast, there are plenty of major companies -- such as Alpharma (ALO, news, msgs) -- 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.

When bad news is good news

Quite the opposite, the Florida-based firm argued in a controversial report published late last month. The Davis research shows that in the years since 1958 in which S&P 500 ($INX) 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, he thinks good news and optimism tends 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. NutriSystem (NTRI, news, msgs), 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 sub par, 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 traditional 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 due to 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 is getting ready to put his bull on. On Friday, he said 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."

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