Earnings season begins to wind down this week. About 20 or so S&P 500 companies will report, compared with almost 350 companies that released results during the last three weeks. During this recent flurry of earnings activity, it's understandable that investors' focus has been squarely on the here and now. And their reaction to the news has been positive, as the bulk of the announcements have come in above the low expectations put into place prior to the beginning of the quarter. And even if, as in the overall economic data, the direction is still down for earnings (and, it's important to note, sales too) investors have been encouraged by this "less bad" news. But a concern that may sit not far from the here and now is that investors will eventually have to look ahead at the level of earnings that are projected for the next few quarters. This level of expected earnings may not produce the same amount of investor optimism and appreciation.

Much of the debate among investors today seems to be about whether the economy has bottomed, and if so, what a recovery will look like. Will it be a strong V-shaped recovery, or will it be subpar when compared with previous recoveries following economic recessions? And are earnings likely to rebound strongly if the overall economy's recovery is tepid? There is an important divergence developing regarding this last question in particular, with different groups of analysts and investors coming to starkly different views on the question.

The graph below attempts to put the expectations for a recovery into context by comparing two measures of economic performance to the typical recovery they've experienced after other post-war recessions. The top plot compares the change in the unemployment rate with the typical change in the unemployment rate following past recessions. The bottom plot compares the current forecast for GDP growth with typical changes in output following past recessions. The blue lines in each plot trace the average change of each of the economic series during recoveries. The red lines trace the current median forecast for that data series over the next year and half or so. The starting point is June 30th, as that is when economists as a group expect the economy to begin to expand again.

While most economists are now expecting the economy to begin to recover in the second half of the year, most also agree that it will be an extremely mild expansion. One reason for this is that the job market is expected to continue to worsen into the middle of next year. You can see this in the top plot. Although the unemployment rate typically continues to rise following the end of recession, during the expected recovery the unemployment rate is forecasted to rise higher and for a longer period of time than is typical. This will continue to put pressure on the two-thirds of the economy's output that relies on consumer spending.

Slow consumer spending, in turn, will likely slow any growth in GDP over the next few quarters, and output growth will likely lag considerably when compared with the typical period of recovery following recession, according to current forecasts. This is in contrast to typical recoveries following severe contractions. To borrow a statistic from Alan Blinder's recent Op-ed piece in the Wall Street Journal: GDP growth averaged 7.7 percent during a six-quarter spurt following the 1982 recession. Over the coming six quarters economists polled by Bloomberg expect the economy to grow at an average of 1.7 percent. The recent downturn wasn't a typical post-war recession, and it's unlikely to enjoy a typical post-war recovery.

The expectations for earnings growth are loftier, especially when compared with the economy's expected trajectory. To put profit expectations into perspective, operating earnings for the S&P 500 peaked at about $91 a share in the second quarter of 2007. Trailing 12-month earnings ending in the second quarter will likely finish up at about $40 a share. This number is expected to increase to $55 a share by the end of 2009, as the ugly 4 th quarter of 2008 drops out of the calculation. By the end of the second quarter next year, Wall Street analysts expect earnings to be at about $65 a share, and then finish the year at $75 a share, recovering more than two-thirds of the decline in profits in just a few quarters.

While these expectations are not completely out of line with recent recoveries following deep profits recessions - like in 2002 & 2003 - the important distinction to make is that these past profit recoveries have typically occurred alongside above-average economic growth. Now there's not a one-for-one relation between economic growth and earnings growth - earnings growth can differ from output growth because of trends in labor, in wages and compensation, in productivity trends, and in profit margins. But while the two aren't a perfect pair, there is a tendency for strong earnings growth to accompany strong economic growth, as the graph below shows.

The graph above plots the year-over-year change in nominal GDP against the year-over-year change in S&P 500 earnings growth. The upward trending line suggests that higher earnings growth typically coincides with faster economic growth. For example, the profits recovery beginning in 2003 coincided with year-over-year nominal GDP of greater than 6 percent, on average.

The graph also shows where the current forecast for earnings growth is in relation to what is expected for GDP growth. The strong earnings growth that's expected can be partly explained by the deep drawdown during this profits recession (to levels where profits approximately bottomed in 2002). So a large rebound might be expected from this lower base. But even if we were to normalize the earnings rebound - let's say 20 percent earnings growth over the next few quarters - within the context of the chart we'd still expect that growth to coincide with economic growth roughly twice than what is currently expected.

Stock investors are probably too focused on the day-to-day announcements of second-quarter earnings to contemplate the divergence between how fast the economy is likely to grow once it recovers and what is already forecasted for earnings growth. But very strong earnings growth typically coincides with above-average economic growth. So one of these groups will likely turn out to be wrong (and maybe both, since we cannot rule out that the economy and earnings continue to contract). Once the current earnings season concludes, investors may begin to contemplate this divergence more seriously.

Lower Income Expectations Add to the U.S. Consumers Burden

Delivered alongside the deluge of earnings data during the past couple of weeks have been important updates about the consumer. Most of the data related to consumer attitudes and consumer spending worsened from recent trends. The second-quarter GDP report showed that consumer spending fell at a 1.2 percent pace, versus a forecast for a .5 percent decline. Revisions to earlier data showed that consumer spending has been weaker during this recession than originally estimated.

The Conference Board's July reading of the consumer showed that sentiment measures that had been improving mostly reversed. Overall confidence fell, along with measures of consumer attitudes toward current and futures expectations. Those surveyed that thought jobs were plentiful fell to its lowest level of the recession and its lowest point since the 1982 recession.

These data points will be important to watch. As John Hussman has been noting, sustained economic expansions are typically driven by growth in gross investment and durables of the large, debt-financed variety like housing autos, equipment, factories, and capital spending. But with the process of economy-wide deleveraging still in its early stages, the contributions that credit-sensitive investments make toward growth may be weak. That would put more of the burden on consumer spending in any early-stage expansion. As John recently wrote, "That's not to say that we can't observe positive GDP growth in the next quarter or two. Unlike past recessions, consumers have uncharacteristically cut back on even nominal consumption - reflecting what they evidently see as a permanent downward revision in their expected lifetime income (U.S. consumer spending patterns are very consistent with the Friedman and Modigliani's permanent income hypothesis). To the extent that consumers abandon these concerns, we may very well observe some recovery in consumer spending sufficient to generate one or two positive GDP figures."

More "less bad" news arrived about the job market on Friday, when there were fewer cuts in nonfarm payrolls than economists were expecting, and average weekly hours ticked up for the first time in almost a year. Going forward, equally as important as the prospect for an improving job market will be the prospect for improving employee and consumer sentiment. Recent readings on sentiment haven't been encouraging, and it is little wonder. Jobless claims are still near the highest levels seen during typical post-war recessions. Inflation expectations are also on the rise, probably as consumers contemplate the ever rising IOU's the government has been or is planning to issue. The Expected Misery Index , a twist on the traditional index, which adds up the difficulty workers are having finding a job and their expectations for inflation, is as high now as when I first mentioned the index in June of last year. This helps explain why the consumer surveys have recently given back some of their recent improvements.

Confidence in staying employed is one part of what supports consumer spending. Another is the expectation of rising wages. On this topic, the message consumers have been sending is worth highlighting. In the most recent survey data, the University of Michigan reported that in July the fewest consumers in the survey's 60-year history reported income gains , and that respondents expected their incomes would be essentially unchanged during the next year, according to The Wall Street Journal. The paper quoted the survey director saying that while consumers feel that the economic freefall is now over, they see little reason to believe that the economic stimulus package will improve their finances anytime soon. Recent surveys conducted by the Conference Board deliver the same message: consumers have very low expectations that their incomes will keep pace with inflation. And while this might be expected during a recession, it's actually rare. The graphs below attempt to put this into context.

The two charts on the left show how consumers feel about their prospects for employment in six months. The chart in the upper left shows the percentage of respondents who are optimistic about their job prospects in six months. The bottom left chart shows the spread between the percentages of respondents who are optimistic about employment prospects versus those who are pessimistic. As usual, consumers have been despondent about job prospects during the recession. You can see similar dips in optimism in 1974 and 1982, and lesser declines during the 1991 and 2001 recessions. It's also worth noting that consumers' attitudes toward future employment have improved recently from very low levels.

The two charts on the right track the attitudes of consumers about the expected levels of income in six months. The chart on the upper right tracks the percentage of respondents who are expecting to have higher incomes in six months. The chart in the lower right again tracks the spread between those that are optimistic and those that are pessimistic. These two graphs differ substantially from the prospects for employment. The outlook for higher levels of future income rarely gets as depressed as it does for the prospects for employment. Even during prior recessions, the percentage of respondents who expected higher incomes consistently stayed above 15 percent. (It's also interesting to note that expectations for higher income didn't snap back from the 2001 recession as they had following earlier recessions - this tendency tracked actual household income which grew only modestly during the last expansion.)

The second point to make about income expectations is that this series hasn't materially bounced back, even with the Orwellian-like delivery of the Green Shoots message. This probably goes a long way toward explaining the continued upturn in the savings rate. During the most recent economic expansion, a declining savings rate was was spurred by consumers rising assets (first stocks then homes) which padded growth in incomes, making consumers feel wealthy enough to consume their entire incomes. Since asset appreciation, when it comes, is likely to be modest, new spending will be more dependent on rising incomes. The American consumer may have rediscovered their prior generation's austerity, and a real secular shift in spending patterns may be to come. But near term, the outlook for consumer spending probably relies more heavily on expected, and then actual increases in real income. The message from consumers is that they don't expect their incomes to be rising soon. And with rising inflation expectations, most consumers may be assuming that their purchasing power is set to decline.

These three components - the health of the job market, the expectations for rising wages, and the confidence in the ability to keep those rising wages after inflation - have historically been a good guide in tracking the changes in consumer spending. I've updated a graph below that I first presented in Consumer Spending Break-Down , which was based on work originally done by Joe Ellis. The blue line tracks the year-over-year changes in real consumer spending. The red line tracks the sum of the changes in employment and the changes in real wage growth. (I made a small change to the chart from its original version - I deflated wage growth by expected inflation from the time at which that series became available. With the spread between expected inflation and trailing inflation at record levels, consumers are likely to form their assumptions of real wage growth on expected inflation rather than recent price changes.)

Tracking these drivers of consumer spending has proved helpful during the past year. In April of 2008, this proxy for spending had just broken into negative territory while actual consumer spending was still slightly positive. A contraction in spending followed. The proxy recently declined further fueled by the persistent weakness in the job market and slightly negative expected real wage growth.

Fiscal policy - including stimulus checks and unemployment benefits - may temporarily alter the dynamics of income and spending. The contribution of overall compensation (wages and salaries, mostly) to personal income has declined meaningfully during the last two years to about 64 percent. Meanwhile government transfer payments have risen from less than 15 percent to almost 20 percent, helping to offset the contraction in wages. That has helped mitigate the decline in household incomes compared with the drop in wages. Incomes have declined 3.4 percent on a year-over-year basis; wages and salaries are off by nearly 5 percent. Without additional stimulus plans consumers may begin to feel the effects of weak wage growth more directly. Data points that shed light on real incomes and income expectations will be important to watch over the next few months.

So will the forecasts for earnings. A substantial earnings recovery is the average forecast, which will likely depend on a robust economic recovery. This would likely need some participation from the U.S. consumer. It's difficult to imagine this chain of events developing smoothly without the consumers getting some help from an improving job market, and just as important, from the expectation of rising real incomes.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).