Earnings growth: How much and how fast?

We can tire out a lot of brain cells trying to figure out where the stock market is going. There are all sorts of inputs to the stock valuation process, almost all of which involve forming an opinion about the outcome of future events.

If we know the future with some certainty, it’s not hard to figure out the value of stocks and the level of returns we would expect to make.

If investors, as a group, have a perfect forward vision of the future of corporate earnings, then stocks would always be fairly priced and the market would never get over- or under-valued. As a side note, I will point out that, absurd as this concept seems, it is included as the principal underlying assumption in the Nobel-winning creation of the so-called Modern Portfolio Theory.

They don’t give out Nobels for theories that rely on the existence of Santa Claus, and I don’t understand why they gave out a few for Modern Portfolio Theory.

Alas, the folks in Sweden don’t consult with me on these matters.

The backdrop of today’s stock market is the unprecedented rise in the earnings of America’s large companies. Since bottoming out in early 2002, the earnings per share of the companies in the S&P 500 have risen at an annual rate of more than 25 percent.

Earnings grew at an 18 percent clip over the 12 months that ended in September 2006. Earnings have not only recovered since the brief recession in 2000-2001, they have done so with a vengeance.

One prominent analyst has called the last five years the golden age of profitability. Corporations are earning record profits at record growth rates, at record profit margins. It just doesn’t get any better than this, and it has never been this good.

The only thing that dampens my enthusiasm for stocks in these companies is the relentless trend of all things financial to revert to historic norms and averages. In the post-war period, the American economy has grown at a remarkably stable rate of about 3 percent after inflation. The only major hiccups in that trend occurred in the 1973 to 1982 period.

If we plot inflation-adjusted corporate earnings against the real gross domestic product, we can see that corporate earnings go though wild swings, moving far below the trend line for the whole economy and then back up again.

And that’s the thing. Per-share earnings move below the economic trend line and back up to it, but they have never managed a sustained move above the economic trend. The recovery of corporate America over the past five years has moved the earnings trend from a plunging descent after the tech burst of 2000-2001 to a position above the trend line today.

Corporate earnings cannot grow, on a sustained basis, faster than the entire economy. After all, the size of the economy is defined by its business activity.

One of two things must eventually happen: either the economy grows faster to catch up to business or business slows down to the rate of economic growth. This is as true as the sun rising in the east and setting in the west.

Today, real corporate earnings have moved significantly above the real GDP trend line for the first time since the latter half of the 1960s. Not surprisingly, those years are also recognized as some of the best economic years of our nation’s history, and were accompanied by a strong bull market in stocks.

So, what does the earnings forecaster do with this information? Conventional earnings forecasting attempts to go out in the world and tally up what everyone is buying and selling and make predictions based on that data.

I’m not trying to forecast earnings levels. I’m not that smart. What I try to do instead is judge whether or not the trend line is materially above or below the mean, and whether or not the invisible hand of the market is likely to push up or push down from here.

I would expect that earnings stabilize at current levels or begin to decline. When might that happen? No one can say with any certainty.

The longer the upward trend goes on, however, the more rapid and damaging will be the eventual correction. As the old saying goes, if something can’t go on forever, it won’t.

Related posts:

  1. A surfing lesson can fast-forward your learning
  2. A few pointers on how to buy bonds on the cheap
  3. 50th Congressional District race flooded with cash
  4. ‘D’ stands for disappointing

Short URL: http://www.lajollalight.com/?p=9060

Posted by Staff on Oct 16, 2006. Filed under Archives. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry

Leave a Reply

La Jolla Community Calendar

Facebook

Bottom Buttons 1

Bottom Buttons 2

Bottom Buttons 3

Bottom Buttons 4

Bottom Buttons 5

Bottom Buttons 6

RSS North Coastal News

  • Balkan folk music on tap Aug. 27 at Carmel Valley library August 20, 2014
    A special free family program of Balkan folk music, sponsored by the Friends of the Carmel Valley Library will be presented at 7 p.m. Wednesday, Aug. 27 in the library’s community room. […]
  • Del Mar bodysurfer winner at world championships August 20, 2014
    Dr. Chris Lafferty, 56, of the Del Mar BodySurfing Club won first place in the 2014 World Bodysurfing Championships in the Mens 55-64 years age division. […]
  • Fall Ball program coming to North Coast area August 20, 2014
    BaseballASAP is pleased to announce that it is offering a 2014 North Coastal Fall Ball program to serve Carmel Valley, Del Mar, Solana Beach, Rancho Santa Fe, Cardiff, Encinitas, and Carlsbad. […]