A boomerang is defined as a curved wooden club or missile designed to return to the one throwing it. Anyone not familiar with the concept of a boomerang may end up with a lump on his or her noggin.
What does investing or corporate earnings have to do with a boomerang? Earnings tend to return to their mean just as boomerangs return to the thrower. Every year more investors get hurt by mean reversion of earnings than boomerangs.
2007 Earnings Forecasts
Mean reversion is a contrarian process, and therefore, always comes as a surprise to investors. In 2007 Wall Street analysts expected operating earnings for the S&P 500 (SNP:^GSPC - News) to exceed $113, an all-time high.
I think we can agree that neither the S&P nor the Dow (DJI:^DJI - News) or Nasdaq (Nasdaq:^IXIC - News) delivered on those expectations. The S&P's operating earnings dropped as low as $49.51 in 2008 and continued to slide early 2009.
2009 Earnings Forecasts
In March 2009 Goldman Sachs predicted earnings to be $40, Merrill Lynch saw $46 and Citigroup $51. At the same time that every major brokerage house on Wall Street slashed earnings, the ETF Profit Strategy Newsletter issued a strong buy alert on March 2, 2009.
2010 Earnings Forecasts
Contrary to Wall Street predictions, earnings recovered. By April 2010 earnings were back to $66, the highest reading in nine months. The headlines below express the optimism of April 2010:
April 14, 2010: "Economic rebound gains strength" - AP
April 19, 2010: "America is back - The remarkable tale of an economic turnaround" - Newsweek
The April 16 ETF Profit Strategy Newsletter, on the other hand, warned that: "Recent price action is building the foundation for a fast and furious decline." The "Flash Crash" happened less than 3 weeks later, and by the end of June, the S&P had fallen 17%.
2011 Earnings Forecast
By April 2011 earnings recovered to $87, the fourth highest reading ever. Bloomberg wrote that the "Biggest profit gain since 1900 sustains S&P 500 after rally." The Wall Street Journal ran an article titled: "The 'what me worry?' market" the Associate Press noted that: "Sales growth is the big surprise on Wall Street."
The ETF Profit Strategy Newsletter was less optimistic and warned that: "S&P 1,369 - 1,382 is a strong candidate for a reversal of potentially historic proportions." From May to September the S&P lost 20%.
What's the moral of the story? Strong earnings aren't bullish, especially if earnings are as unevenly distributed as they are this time around.
Tech sector (NYSEArca:XLK - News) earnings growth is 11%. Tech sector earnings, minus Apple, is -2%. Apple accounts for about a third of the S&P (NYSEArca:SPY - News) earnings growth. Without Apple, the S&Ps growth drops from about 6% to 4%.
The Risk of Mean Reversion
The chart above plots the S&P against earnings since 1998. All major market tops coincided with record earnings. Q1 2012 operating earnings are expected to come around $98, a new all-time high.
Earnings projections for the remainder of 2012 and 2013 go as high as $119. The chart shows the direction of earnings projections at previous highs or lows. Analysts did not see any of the mean reversions coming (just like now), but mean reversions are as predictable as a boomerang. Unless you pay attention, you'll get "hit."
The most recent ETF Profit Strategy Newsletter visually and statistically illustrates the massive risk associated with owning stocks when A) earnings are at all-time highs and B) entire European governments are at the verge of collapse.
However, it is important to view the recent market action in combination with technical indicators. The Fed has been able to "fool" fundamental market forecasting, but not technical indicators. One of those indicators is support/resistance levels.
Once stocks break below key support levels they tend to drop much further as selling creates panic (like in 2010, 2011 - imagine a person walking on thin ice; once the ice breaks, there is no return). The ETF Profit Strategy Newsletter pinpoints the key support level - that once broken - will be a sell signal and likely lead to much lower prices.
More From ETFguide.com
