In confidence-driven bear markets, on the other hand, company earning power remains as expected; all that erodes is the willingness of investors to pay up. That, historically, has taken less time to recover—about six months.
If we got a bear market (i.e., a decline of the S&P 500 to around 1,710), the earnings yield would be around 7.4 percent, based on earnings estimates. In other words, if you owned all of those companies, at market value, you would be making 7.4 percent in earnings. With bond yields where they are, that looks like an attractive investment and should draw investors back to the market.
The Path To Renewed Confidence
For confidence to return, though, investors would have to believe that those earnings estimates are correct. What would that take?
Some proof that earnings will match expectations. Earnings are expected to decline for the third quarter in a row, so positive surprises would help restore confidence. This is quite probable, as companies usually guide expectations lower in order to beat them. It's a two-sided game, however, since the lower current earnings are, the more easily they can be beaten in the future. Given the decline in earnings this past year, even modest improvement will likely allow for increases next year.
A rebound in the oil price. Energy and materials have been the major drag on corporate profitability, and even a modest recovery in prices would help create the earnings growth just mentioned. Plus, historically, low oil prices have meant a slowing economy. Although the markets are different now, a rising price would aid in the perception of growth and boost confidence.
Continued growth in the global economy. If U.S. hiring continues at current levels, for example, the strength of the consumer will ultimately lift corporate revenues and profits. If China demonstrates that it has taken control of its problems, growth concerns there will abate. The same applies to other countries.
Note that all of these factors can occur in a couple of quarters, or about the six months that confidence-driven bear markets have taken to recover in the past.
I’d rate the probability of the first factor occurring as quite high. Companies are cutting costs and doing everything they can to adjust to the current environment and resume earnings growth. With expectations getting lower by the day, positive surprises become that much easier to pull off.
As for oil, prices may well increase, and, as mentioned, it wouldn’t take that much to have a positive effect. In any event, expectations for oil prices are now at rock-bottom levels, so some improvement in expectations seems quite probable. Finally, low oil prices actually have a very stimulative effect on the real economy, even more so in China and Europe than here, so the recent drop will help the third component (global economic growth) continue.