How to Profit from the S&P 500—Even if Earnings Disappoint

I was reading an article that suggested investors are underestimating the extent that U.S. corporate profits could grow in 2014. And that the only reason the U.S. economy reported disappointing retail sales and weak jobs numbers and manufacturing data was because of the harsh winter weather. (Source: Shmuel, J., “Are EPS estimates currently too low?” Financial Post, February 18, 2014.)

Fortunately, so the story goes, the economy is so red-hot that once the snow thaws, investors will be rewarded with solid quarter-over-quarter corporate earnings growth. This suggests the weather has not just blinded investors to the fact that the economy has recovered (which it hasn’t), but that we are also so short-sighted that we can’t see the great gains waiting for us just around the corner—because if there’s one thing investors lack, it’s a desire to make money on the stock market…

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I think investors are losing faith in Wall Street’s earnings potential because the corporations that go into making up the S&P 500 continue to warn us that their earnings are not going to be as great as they had hoped. And it’s not as if this is a new phenomenon.

Throughout 2013, as the S&P 500 marched steadily higher, an increasingly larger number of companies revised their earnings guidance lower each quarter. During the first quarter of 2013, 78% of S&P 500 companies that provided preannouncements issued negative earnings guidance; the second quarter came in at 81%; a record 83% of S&P 500 companies issued negative earnings guidance in the third quarter; and another record 88% did so in the fourth quarter.

For a country that is supposedly in the midst of an economic recovery, 2014 is not starting out on the best footing. For the first quarter of 2014, 80% of the S&P 500 companies that have issued guidance revised their earnings lower; this compares to 78% of S&P 500 companies that did so in the first quarter of 2013.

The overly optimistic analysts on Wall Street that have been pronouncing that the economy is all but recovered have been taking note. In one of the quickest about-faces, analysts have revised their first-quarter earnings expectations lower as well. On December 31, analysts were expecting firms on the S&P 500 to report first-quarter earnings growth of 4.3%. Today, that number sits at a paltry 1.2%.

The article I was reading went on to suggest that investors ignore the correlation between gross domestic product (GDP) and corporate profits. And that stocks increase by around 6.5% for every one-percent change in real GDP. So, if GDP improves according to projected forecasts, earnings estimates will rise and so, too, will stock prices.

Unfortunately, first-quarter 2014 GDP growth of 4.2% is looking less and less likely. For starters, jobs numbers continue to disappoint, wages are flat, retail sales are weak, housing data is either down or missing estimates, and January car sales were off.

It’s also hard to reconcile a strong first-quarter GDP growth rate or robust 2014 GDP growth in light of a slowing economy. In 2013, the U.S. experienced full-year GDP growth of 1.9%—that number was 2.8% in 2012.

If the S&P 500 is only as strong as the stocks that make up the index and the stocks are a reflection of the economy, it’s not a total surprise to see why some investors are unsure of Wall Street’s earnings potential.

Those investors who are confident that the U.S. economy is on solid footing could consider an exchange-traded fund (ETF) that tracks the broader S&P 500, like the SPDR S&P 500 SPY ETF trust. Or, if you think earnings will continue to disappoint, you could research an ETF that shorts the S&P 500, like the ProShares Short S&P500 SH.

This article How to Profit from the S&P 500—Even if Earnings Disappoint was originally published at Daily Gains Letter