Earnings season for the third quarter is almost done. It looks like the companies in the S&P 500 will report earnings per share that are 2.2% lower than they were a year ago. It will be the third straight quarter of year-over-year declines.

This is a concern for two reasons.

First is the fact that companies often make adjustments to earnings. This is called non-GAAP earnings, and it excludes one-time factors and special charges the company’s management thinks will distort the true picture of operations.

GAAP, or generally accepted accounting procedures, defines how earnings are calculated. A company’s management will often argue that some charges, like corporate restructuring or layoffs, artificially depress earnings. To help investors factor in these items, they report non-GAAP earnings.

FactSet reports that, on average, about 73% of companies release non-GAAP earnings. On average, 75% of the adjustments increase earnings, and the average increase is more than 10.9%.

My first concern is that companies are using accounting changes to increase earnings, yet earnings are still lower than they were a year ago. My second concern is that earnings growth has accounted for more than 80% of the stock market gains in the bull market.

Recently deceased Vanguard founder Jack Bogle attributed long-term stock market returns to dividends, earnings growth, and changes in the price-to-earnings (P/E) ratio. In his research, those three factors explained all of the market’s returns. The table below shows the source of gains over time. Note the extraordinary contribution from earnings growth in the past decade.

_{Source: Fortune}

This is bearish in the long run. The average dividend yield for an S&P 500 stock is about 1.8% right now. Earnings are dropping, and we can expect them to decline significantly in a recession. Earnings fell 52% in the 2008 recession and about 30% in the recessions that began in 2001 and 1990.

Neither of those factors will deliver above-average returns. That leaves changes in the P/E ratio. The chart below shows the current P/E ratio is above average.

_{Source: S&P Capital IQ}

The current P/E ratio is 27.4. The all-time high was 34.4 in December 1999. A return to that level could boost stock prices by 25% — not enough to offset the decline in earnings we are likely to experience in the next recession.

What This Means, And How I’m Trading It

All this means that we will likely see lower-than-average returns over the next few years. That means investors would be wise to focus on short-term strategies, like the one my subscribers and I use over at Income Trader. This strategy should help us to sidestep the steep declines that will characterize the next bear market — while participating in the “up” moves that will interrupt the decline. Even better, we’ll earn consistent reliable income from a strategy that’s delivered successful trades more than 90% of the time.

In the short run, it’s likely we will see strong gains in the next few weeks as momentum and seasonal factors are bullish into the end of the year. But, first, a pullback is likely — although we might have already seen it. My proprietary Income Trader Volatility (ITV) indicator turned bearish on the SPDR Dow Jones Industrial Average ETF (NYSE: DIA) last week, but is bullish again.

On the chart, I’ve added a line showing that support coincides with a 38.2% retracement.

After a rally, traders look for prices to pull back. Many traders plot retracement lines to show important price levels. Fibonacci ratios are a popular tool, which mark pullbacks that measure 38.2% and 61.8% of the advance. Some assign mystical qualities to Fibonacci numbers, but the reality is that this tool is included in all major software packages and is available for free on many websites. Many traders use them simply because they’re available. I’ve spoken with hedge fund traders that use them, as well as analysts at major Wall Street firms. They should never be the only tool a trader relies on, but they can be useful when combined with others. In the chart above, the Fib ratio lines up perfectly with support on the chart.

The chart indicates a 2.5% pullback is likely before we see the market rally sharply into the end of the year. For now, that’s what I am looking for, but, as always, my outlook will change as the indicators change.

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