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.

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