The 'rally point indicator' perfectly predicted the stock market's logic-defying comeback

·Contributor

Sun, Mar 20, 2016, 7:23 AM

The stock market continues to be a rollercoaster-ride for investors. After tumbling to as low as 1,810 on February 11, the S&P 500 (^GSPC) rallied all the way to 2,049 on Friday after booking five consecutive weeks of gains.

While it’s generally not a good idea to make too much of short-term market moves, two jarring charts caught our eyes and nail down what’s happened in recent weeks.

The rally defies logic

The recent rally occurred during a period when analysts had been slashing their expectations for earnings, which is odd because earnings are arguably the most important drivers of stock prices.

“As a result of the downward revisions to earnings estimates, the estimated year-over-year earnings decline for Q1 2016 is -8.4% today, which is below the expected earnings growth rate of 0.3% at the start of the quarter (December 31),” FactSet’s John Butters said on Friday.

While there tends to be a bias to cut earnings estimates during a quarter, the recent cuts have been particularly pronounced.

“On a per-share basis, estimated earnings for the S&P 500 for the first quarter have fallen by 9.0% since December 31,” Butters wrote. “This percentage decline is already larger than the trailing 5-year average (-4.0%) and trailing 10-year average (-5.3%) for an entire quarter.”

So, what gives?

Unfortunately, there’s really no simple rational explanation for why earnings and stock prices will diverge in the near-term (See here, here, here, and here). However, investors may find some comfort knowing that this relationship between price and earnings tends to correct in the long run.

Oppenheimer's 'rally point indicator' nailed the recent bottom

Speaking of relationships between price and earnings, the most commonly referenced relationship between stock prices and earnings is the price-to-earnings (P/E) ratio.

While the P/E ratio is not considered to be a very reliable indicator of short-term returns, one Wall Street analyst noticed an interesting pattern emerging in the past two years.

“[O]ver the course of the last two years we have noticed the tendency for the S&P 500 to rally from selloffs when the market’s trailing 12-month P/E multiple falls to a level of around 16.5x,” Oppenheimer’s John Stoltzfus said in a February 17 note to clients. “Since 2014 through last week this has occurred on six occasions when the S&P 500 multiple fell to levels ranging from 16.46x on February 3, 2014 to most recently when the 12-month trailing P/E multiple touched 16.47x on February 11, 2016.”

As we mentioned above, February 11 was when the S&P 500 touched its low of the year.