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Forget the "Death Cross" -- These 2 Factors Will Drive Stocks

By Alex Dumortier, CFA - May 18, 2016 at 12:34PM

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The S&P 500 has reportedly produced a "death cross" price pattern -- but investors should ignore that. Instead, they ought to be focusing on earnings growth and valuation.

U.S. stocks are somewhat higher in early afternoon trading on Wednesday, with the S&P 500 (^GSPC 1.05%) and the Dow Jones Industrial Average (^DJI 1.05%) (DJINDICES: $INDU) up 0.17% and 0.05%, respectively, at 12:15 p.m. ET.

I like Bloomberg.com; I think it's one of the best sources of financial and economic news. However, it's not above publishing over-hyped nonsense in order to capture eyeballs (it's no different from other news outlets in this regard). One of today's stories, under the ominous title "This S&P 500 Death Cross Could Be The Real Deal" is a fine example of this (my emphasis):

...the S&P 500's 50-week moving average is falling below its 100-week moving average.

This "statistically significant" death cross has only happened twice in the past two decades, Laidi points out. The first took place in 2001 and was followed by a 37 percent decline in the index, while the second pattern occurred in 2008 and preceded a 48 percent drop.

To paraphrase "The Princess Bride": This expression, "statistically significant" -- I do not think it means what you think it means. Twice in two decades is an outlier, not a statistically significant relationship.

Trying to divine anything from a "death cross" and other technical analysis indicators is nothing more than financial voodoo. Don't let this type of headline scare you out of stocks. Over the long term -- which is, in any case, what investors ought to be focused on -- earnings growth and valuations are what drive stock returns. That relationship is logically sound and statistically significant.

Speaking of those two factors, in a note published yesterday, Goldman Sachs' Portfolio Strategy Research downgraded stocks to Neutral with the following explanation:

We downgrade equities to Neutral over 12 months on growth and valuation concerns ... Until we see sustained earnings growth, equities do not look attractive, especially on a risk-adjusted basis.

With over 90% of companies in the S&P 500 having reported first-quarter earnings, it's now clear the index will record its fifth consecutive quarter of year-over-year earnings declines. As recently as the end of March, the consensus estimate for the second quarter implied positive growth (albeit by a hair: +0.5%).

At present, the consensus estimate for the current quarter -- and for the six quarters beyond that -- implies a sharp rebound in earnings:

Surely, that's the "sustained earnings growth" Goldman is looking for. The trouble is that the index earnings estimates, which are aggregated bottom-up from company estimates, appear to systematically reflect the best of all possible worlds. Keep in mind that the first-quarter estimate came down 10% as the quarter progressed (and 16% from 12 months prior!).

Neither Goldman nor anyone else has any idea what the stock market is going to do over the next 12 months. However, they're not wrong in highlighting the fact that earnings growth and valuation are headwinds. There is nothing wrong with expecting the best -- as long as you are prepared for the worst (or the bad, at least). Whether it be over the next 12 months or over the next 3 to 5 years, investors ought to be prepared for muted returns and plan accordingly.

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Stocks Mentioned

Dow Jones Industrial Average (Price Return) Stock Quote
Dow Jones Industrial Average (Price Return)
^DJI
$31,097.26 (1.05%) $321.83
S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
^GSPC
$3,825.33 (1.05%) $39.95
The Goldman Sachs Group, Inc. Stock Quote
The Goldman Sachs Group, Inc.
GS
$299.23 (0.74%) $2.21

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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