Tuesday, January 26, 1999

If you didn't like the last three years in the stock market you've got a major problem. The Standard and Poor's 500 Index provided an annualized return of 28.22 percent. That means Index fund investors saw their money double.

Unfortunately, most people didn't get returns like that because more typical stocks and funds provided returns about half as large.

Which brings us to the future.

On Sunday I showed the rosie view from Wall Street. Of nearly 4,000 stocks for which analysts had made long-term earnings estimates, the median was a 16 percent compound growth rate. More important, every company in that universe had a growth rate that was positive, even if anemic. Based on those expectations, a reasonably diversified investor could count on his portfolio doubling once again over the next five years. That, as they say, is "nice work if you can get it."

Will it happen?

Recent history says no.

You can understand by examining actual results over the last three years.

We start with the same universe of nearly 4,000 companies blessed with long term analyst estimates for earnings. When we take that group and look backward, we find that 1,600 companies disappear because their actual earnings figures over the last 3 years were "NMF" or "Not Meaningful." This usually happens when a company was losing money three years ago but is making money now.

Of the remaining 2,359 companies, the bottom 20 percent have negative earnings growth rates that get your attention— minus 14.5 percent to minus 1.8 percent. Another 10 percent of companies had earnings growth that was modestly negative to less 5 percent. The remaining 1,600 companies showed growth rates ranging from 5 percent a year to 460 percent. For the entire group, the median was 14.1 percent a year. (The distribution is shown in the table below.)

Trailing Growth Rates for 2,359 Stocks

Decile Growth Rate Range, Trailing 3 Years
Top 10 percent 52.6 to 460.2 percent
2nd 33.3 to 52.6
3rd 24.8 to 33.3
4th 18.8 to 24.8
5th 14.1 to 18.8
6th 9.6 to 14.1
7th 5.0 to 9.6
8th -1.8 to 5.0
9th -14.5 to -1.8
10th -81.8 to -14.5

Source: Morningstar Principia Pro, December 31 data

Are there some messages here?

Yes.

First, the median analyst expectation for future earnings growth was 16 percent compared to actual growth over the last three years of 14.1 percent. That should give you some idea of the amount of optimism in the forecasts. Analysts are projecting superior growth will extend one of the longest economist expansions in history and this is occurring while the outside world moves to recession, deflation, or worse.

Second, the orderly world of analyst projects has no room for declining earnings. But more than 20 percent of companies suffered earnings declines over the last three years. What is going to prevent more than 20 percent of companies from suffering earnings declines over the next three years?

Third, all this is happening in an environment where virtually all the sources of potential stock buying have been tapped. Everyone is already fully invested. Mutual fund buyers, in and out of qualified plans, are already choosing stocks over bonds and cash about as heavily as they can.

Fourth, many conditions that benefited corporate earnings in recent years are gone. Corporations have reduced their debt. What remains has been refinanced at lower rates. Interest rates are at their long-term averages and have little room for further decline. Profit margins are likely to come under pressure as still more boatloads of goods are shipped in from abroad and consumers contemplate their credit limits. And with unemployment at the lost rate in a generation, it isn't likely that corporations will be able to squeeze wage gains.

The bottom-line?

In a market where many stocks are selling at nearly 30 times earnings but expected to grow at less than half that rate, there is a more opportunity for disappointment than for happy surprise.

Gird yourself accordingly. At best, this is a stock pickers market.