Chasing Red-Hot Profit Growth Is a Recipe for Stock Market Pain

A person stands in front of a view of One World Trade Center along the waterfront in Jersey City, New Jersey, U.S., on Monday, April 5, 2021.

— It came as a shock on Wall Street the last few days, how much better the world’s biggest companies were doing than anyone thought.

Thirteen months into the Covid-19 recovery rally, Wall Street researchers have become focused on the question of when in the cycle it pays for investors to wean themselves off companies showing the highest growth rates.

With corporate income quickly vaulting back to pre-pandemic levels amid the best expansion in a decade, the fastest growers are getting no respect.

For now, the higher bars are proving no hurdle for companies to clear, though negative reactions to earnings from stocks like Microsoft Corp., Apple Inc.

To be sure, in a year when all sell signals have been nothing but a sure way to lose money, finding fault with the current robust expansion is like looking a gift horse in the mouth.

But if history is any guide, placing too much faith in perceived high-growth can be a dangerous game.

Such is the burden for companies whose shares embed extremely high expectations, a dream that they’d one day dominate their industries the way Google did in the online search business.

While the study focused on individual companies, the concept appears to apply to the entire market these days, as policy support and vaccines fuel hopes for a roaring economy.

“Dreaming of a reopening is easier than actually doing it,” Wilson wrote in a note.

After being blindsided by the pandemic and staying too conservative about corporate America’s earnings power, analysts are now busy upgrading their forecasts at one of the fastest clips in years.

Ned Davis Research grouped S&P 500 earnings growth since 1927 into five brackets and found that unless it’s really bad — down 25% or more from a year ago — income growth tends to have an inverse relationship with market returns.

The seemingly odd behavior, according to Ned Davis, founder of his name-sake firm, has to do with the market’s inclination to always look ahead.

The S&P 500 rallied roughly 20% in 2017 in anticipation of the boost to earnings when the policy took effect the following year.

Of course, with the pandemic driving monetary policy and the economy into uncharted territory, nothing in the past may be applicable now.

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