I stumbled across this chart during a random perusal of MarketWatch yesterday and was compelled to share. Bears love graphics like these. They suggest the imminent demise of stock prices a la 2008 and support pessimism everywhere … or do they? Allow me to pontificate on the key takeaways from such a chart.

First, let’s make sure we all understand what is being displayed here. The blue line is the S&P 500 Index, the orange area chart in the background reveals the earnings of said S&P 500. You’ll notice both data points possess a generally positive correlation. This is the type of stat that appeals to your inner fundamentalist. The one that understands that actual companies underlie ticker symbols and that, in the end, profits and cash flow are all that really matter.

That means a stock market that divorces itself from fundamental realities is in for some bad juju. Which is why today’s chart has all the Chicken Littles running for cover. See, the last two times profits experienced persistent declines they morphed into full-fledged kamikaze plunges inflicting mass damage to stock prices. We’re talking two of the worst bear markets in history.

Like I said, scary stuff.

Before you get all hide the kids, hoard the canned corn, where’r the shotgun shells on me here’s the counterargument.

First, any data set with a sample size of two should be viewed with extreme skepticism. Two data points means nothing, zip, zero. Just because the last two times X happened, Y ensued doesn’t mean diddly squat. That there could be an aberration. Noise. What would make the chart altogether more insightful is if it looked at more history. Are their instances where earnings experienced four quarter-over-quarter declines and the market didn’t implode? Surely there have been times when the economy stumbled for a spell without snowballing into a vicious stock-killing recession.

Second, never ever forget the market looks forward, earnings look backward. Perhaps the recent market moonshot (the Feb-April rally) reveals the seers of the street are anticipating more profitable quarters ahead. And while the recent earnings decline can be blamed on the inability of the S&P 500 to gain any ground over the past two years, that’s history, baby. And recent buyers are betting it won’t persist.

At some point, however, this starry-eyed belief will fly into the impenetrable wall of reality. I highly doubt prices remain aloft if we see a fifth, sixth, or seventh quarter of earnings decline. Eventually there is a reckoning.

Third, earnings deterioration doesn’t matter until it does. And guess what tells you when it matters? Price. That precious variable worshiped by technicians everywhere. When the S&P 500 starts breaching long-term support levels then we can all head for the hills. Until then, chill out.

Fourth, make sure you have a plan in place for how to deal with the next bear market before it arrives. No one likes the mamsy-pamsy blubbering incoherently as the plane goes down. Just don the oxygen mask, hug the life jacket, and enjoy the ride. You won’t die …. probably.

Perhaps we’ll revisit bear market preparation another time. The ultimate survival guide or some such. Stay tuned.

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