The seemingly prudent consensus these days is that corporate earnings growth will slow from the torrid double-digit pace of the last few years and settle in at a more normal rate of, say, 6% per annum (the long-term average). Alas, this consensus is anything but prudent.
As fund-of-funds' manager, analyst, and SMU adjunct professor Ed Easterling writes, earnings just don't behave that way. Yes, they average about 6% a year (6.6% in Ed's 80-year model). But they achieve this average by shooting up for 3-5 years, collapsing for 1-2 years, shooting up for another 3-5 years, and so on. In other words, for all of recorded history, earnings have followed a 3-steps-forward, 2-steps-back pattern, not safe, smooth trend-line growth.
So, what's the problem? Well, as previously discussed, profit margins--"one of the most mean-reverting series in finance" (Jeremy Grantham)--just hit a 50-year high of 14% of GDP, as compared to the 9% average. As Ed Easterling points out, profits have also now grown strongly for 5 years in a row. According to Ed's data, there has been only one business cycle since 1950 in which profits grew for more than 5 years in a row (in the late 70s). In the sixth year of that expansion, moreover, growth was miniscule, and in the following two years, it collapsed--taking the stock market to a 16 year low.
As of this writing, meanwhile, "prudent" forecasters are expecting profits to continue to grow for not only 2007 but 2008--what would be the 7th year in a row. Is this possible? Anything's possible. Is it likely? A review of the business cycles of the past half-century suggests the answer is an emphatic "no."
If, instead of setting a record for consecutive years of impressive growth, earnings behave the way they normally do--collapse for a year or two--what is the stock market likely to do? Happily deliver another two years of low-volatility, near-double digit growth? We could do that math, but then we might be accused of always being the bearer of bad news.
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