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June 5, 2006

The End of Excellent Earnings

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

In recent months, I've emphasized that stocks are far more richly valued than price/earnings ratios seem to imply. The robust earnings growth rates of recent years largely reflected a trough-to-peak move in earnings, right back up to the 6% growth channel that connects S&P 500 earnings from economic peak-to-peak as far back as one cares to look (see the March 20, 2006 comment for a recent chart). With the exception of the late-1990's bubble, if we examine periods where earnings were within 10% of that long-term growth line, the price to peak earnings multiple on the S&P 500 has averaged less than 10. Moreover, once earnings approach that long-term trend line, they have typically contracted at an average rate of -3.39% annually over the subsequent 3-year period.

If investors ignore the position of earnings in the economic cycle, P/E ratios seem benign – certainly not extreme in comparison with the late-1990's bubble valuations. And it's a small step from there to argue that valuations are even bullish. If you watch the financial channels for more than about 20 minutes, you'll typically hear some analyst saying that “stocks are still cheap relative to bonds” – which is analyst-speak for the “Fed Model.” The Fed Model simply compares the earnings yield of the S&P 500 (based on estimates of future operating earnings) to the 10-year Treasury yield. If the earnings yield is higher, the Fed Model is bullish. Suffice it to say that the model has virtually zero predictive value for subsequent stock returns. However, I found several years ago that the model does have some slight redeeming value. It turns out that when earnings yields are low, and Treasury bond yields are even lower, it's not a useful buy signal for stocks, but it's often a pretty good sell signal on bonds.

Why worry about earnings?

There's a clear historical tendency for earnings to drop over the 3-years following an approach of that long-term 6% growth channel. But it would seem almost superstitious to believe that earnings ought to weaken this time around on that basis alone, especially with the economy still seemingly resilient. As always, the difference between analysis and superstition is in asking why a particular relationship should exist, and in understanding the mechanism behind it.

With that in mind, we put together the following chart last week (thanks to Bill Hester for research assistance). The blue line (right scale) depicts U.S. corporate profits as a percentage of nominal GDP. The violet line (left scale, smoothed) depicts U.S. personal disposable income as a percentage of nominal GDP, using an inverted scale – a rising line means a falling disposable income share. Notice that increasing corporate profits as a share of GDP generally come at the expense of wage earners' share, and vice versa. The recent upleg in corporate profits since 2003 reflects a corresponding drop in personal income as a share of GDP (a rising violet line) from 75% to 72% of GDP.

Corporate profit margins (profits as a percentage of corporate revenues) trace out a similar picture. The extent of this widening in profit share and profit margins is unprecedented, and isn't something that's likely to be sustained in a competitive economy. Historically, profit margins have been strongly mean reverting, with large swings as the economy moves between recessions and recoveries. Importantly, it doesn't take a plunging economy or falling revenues to hurt profit margins – even a deceleration of growth is typically enough to put downward pressure on margins.

So while profit margins are at record highs, disposable income as a percentage of GDP is closing in on record lows. The disposable income share was slightly lower in 1980 than it is today. Of course, in 1980, unemployment exceeded 7%, so it was possible to squeeze wage earners to a slightly lower share, but even that was short-lived, as labor compensation grew and profits fell in the next few years.

The effects of profit margins and employment conditions on subsequent earnings growth are important. Once profits become a large share of GDP and unemployment falls to relatively low levels, earnings growth is typically disappointing over the following 2-3 years. In contrast, when profits are a small share of GDP and unemployment is high, subsequent earnings growth tends to be well above-average.

To put some numbers on this, since 1963, when the profit share of GDP has been greater than 6% and the unemployment rate has been less than 6%, profits have crawled along at just 2.13% annually, on average, over the subsequent 3-year period. In contrast, when the profit share of GDP has been smaller than 6% and the unemployment rate has been above 6%, profits have enjoyed an average growth rate of 9.94% over the subsequent 3-year period.

With corporate profits pushing above 9% of GDP, the unemployment rate at just 4.6%, and S&P 500 earnings at the top of their 6% long-term growth channel, investors should not be at all surprised to see “surprising” wage inflation, accompanied by disappointing profit margins and weak earnings growth in the next few years.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. Stocks have enjoyed a typical fast, furious, prone-to-failure advance in recent days, coinciding with a period that tends to have modestly favorable (though less than reliable) seasonality. That period ends about Wednesday, for what it's worth. Given an unfavorable Market Climate, no longer oversold, and without the benefit of seasonal influences, a hedged position remains both comfortable and appropriate for now.

On a medium-term basis, profit margins are high, producing high earnings, on which stocks trade at high multiples (which is a bit like building a human pyramid on stilts). All of these are increasingly vulnerable here. Buy-and-hold investors, enamored with recent earnings, may be standing on far less solid ground than they might believe. Note that this argument isn't about the next quarter or two, which may or may not enjoy reasonable earnings reports. Looking toward the next few years, however, profit margins are more likely to revert toward the mean rather than extend an already overextended run.

In bonds, the Market Climate was characterized by relatively neutral valuations and unfavorable market action, holding the Strategic Total Return Fund to a duration of about 2.5 years, mostly in Treasury inflation protected securities, as well as a continued allocation of about 10% of assets to precious metals shares.

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