The Wall Street expert who called the last stock meltdown explains how investors are falling into a potentially catastrophic trap

Reuters / Brendan McDermid

• Ed Clissold, the chief US equity strategist at Ned Davis Research, says many investors fall victim to a major misconception surrounding corporate earnings growth.
• He says that this misunderstanding could be sending traders down an overly optimistic path that could come back to bite them in the end.

If you were to take a blind survey of investors, most would tell you that corporate earnings are a rare bright spot in a landscape increasingly riddled with macro headwinds.

Ed Clissold, the chief US equity strategist at Ned Davis Research, doesn’t necessarily disagree. But he does think investors are taking that information and drawing the wrong conclusion.

It’s a common misconception that historically strong profit growth translates directly to a bright future for a company’s stock, Clissold says. He argues instead that, at such lofty levels, there’s often nowhere for earnings to go but down — something that doesn’t bode well for a firm’s shares.

To the extent that traders misinterpret peaking profit growth as a bullish long-term catalyst, they’re setting themselves up for disaster, according to Clissold. And he’s someone well worth listening to, considering he successfully called the December stock meltdown at a time when most on Wall Street were still bullish.

"When earnings growth is very high, it’s already priced in, and it’s not sustainable," Clissold told Business Insider by phone.

He continued: "In terms of earnings expectations, when the beat rate is high, the assumption is that it’s a good thing. But actually, over the past six years, the market has done better when the beat rate has been lower."

Read more: Forget the yield curve. Morgan Stanley says investors should be focused on a superior recession signal — one that’s threatening to flash by year-end.

The fourth quarter of 2018 is a prime example of this. While S&P 500 profits grew by 14%, the benchmark index ended up tumbling 14%. That’s because, while conditions looked supportive from an earnings perspective, the market was priced for perfection.

Then — when mega-cap tech stocks re-rated lower and the Federal Reserve failed to give investors the dovish outlook they so craved — the market collapsed, almost ending the nearly decadelong bull market. It was very much a situation where euphoria had peaked, and profit growth was both ineffective and misleading.

But Clissold warns of another separate trap investors should beware during recessionary periods. Put simply, when the economy is contracting, disappointing earnings reports are a symptom of that and shouldn’t be viewed as a bullish indicator. It’s a key caveat for any trader combing earnings results for hints of future stock performance.

"If you’re going into a recession, then the lower beat rate is a signal of that," Clissold said. "If you’re not, it’s just a sign that markets are taking a breather, and beat rates should go back up again, and markets will start pricing that in."

NOW WATCH: The founder and CIO of $12 billion Ariel Investments breaks down how his top-ranked flagship fund has crushed its peers over the past 10 years

See Also:

• A $28 billion strategist flags the multi-trillion-dollar roadblock keeping investors from the stock market’s most hidden gems — and explains his strategies to outsmart it
• A $3 billion investment chief breaks down the strategies he expects traders to use around the Lyft IPO — and reveals how his firm is planning to play it
• The Wall Street strategist who called the last stock plunge says investors are foolishly ignoring one thriving corner of the market

SEE ALSO: The stock market just got hit with a vicious trifecta that could accelerate its next major meltdown

Source: Business Insider – jciolli@businessinsider.com (Joe Ciolli)