“We have found through our analysis that FY2 earnings revision ratios are a useful indicator for trying to determine market inflection points. In our work, FY2 earnings revision ratios measure the number of analysts increasing their earnings estimates relative to the total number of analyst revisions over the prior 60 days. Thus, the actual data is somewhat of a diffusion index, with values greater than 50% indicating earnings optimism and values below 50% indicating earnings pessimism.
Based on our analysis, this indicator tends to work best from extremely low values, which we define as a level at or below minus one standard deviation from the mean. As you can see from Exhibit 1, this indicator recently hit this barrier. More important, we found that S&P 500 performance is quite attractive in the months following such “poor” readings.
By contrast, significant losses have been quite rare. In fact, all of the double-digit losses throughout this period occurred during 2002, which was characterized by uncertainty still surrounding the continued Tech bubble unwind, as well as the 9/11 aftermath. Furthermore, we also found that gains in excess of 30% have been more common than significant losses. Therefore, we view recent levels in this indicator as a positive signal for market performance in the coming months.
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