The following graph shows inflation-adjusted earnings for the S&P 500 for the past 75 years. I often see patterns when looking at charts and have added some visual “guidelines” to the graph.
The implication is that earnings are right where they belong, if the growth trends of the past 40 years are to be continued. This is debatable, of course, for the following reasons:
1. Unprecedented unemployment problems compared to the last 40 years;
2. Continued deleveraging from the credit bubble;
3. Higher energy costs likely inhibiting any growth scenario;
4. Lack of any new economic expansion driver being evident; and
5. The current rebound is the result of temporary inventory rebuilding.
Other arguments could be used to counter the idea that S&P 500 earnings are right where they belong. One is that we have rebounded too fast, resulting in an overshoot that will be pulled back as inventory rebuilding subsides and expense/revenue ratios increase.
Part of the rebound in earnings has resulted from cutting expenses, particularly payroll expenses. If employment starts to improve as payrolls start to increase, productivity growth will probably be reduced, and earnings may give back some of the recent gains. Of course, increased employment should increase consumption. However, a more conservative attitude toward spending may be the new normal. In such a situation, payrolls could increase faster than earnings.
Jeff Miller has questioned a number of things about the discussion up to this point. This will address some of his concerns.
Here is another view of the earlier graph:
This view of the graph sees only one excursion outside of trend: the crash of 2008-09. There was no dot.com stock bubble or credit-derived stock bubble; these two peaks are just high points in the 75-year trend. This trend in real earnings is more than double what was previously proposed as the normal trend. Here the growth rate is about 125% in 45 years (vs. the 50% growth in the earlier view). The 125% rate is 1.8% growth per year compounded.
Jeff has also questioned the adjustment of S&P 500 earnings per share for inflation. He raises a good point; I have not justified that. It may be more meaningful to look at the total earnings of corporations when adjusting for inflation – this definitely would offer a strong measure of real earnings for stocks. The adjustment of earnings per share may or may not reflect the total of earnings.
I also think that real corporate earnings should be normalized to population to get a good measure of national productivity in so far as corporate earnings reflect that. All of these questions will be examined as I develop future articles in my series on the business cycle.
The final takeaway from this discussion is that projections of further real earnings growth occurring in 2010 and 2011 are predicting either (1) a new earnings bubble, or (2) a new normal which establishes a higher trend rate for earnings growth, or (3) continuation of a 75-year trend.
Of course, there may not be further S&P 500 earnings growth in 2010 and 2011, and the entire discussion of bubble or a magical new normal becomes rhetorical.
Many thanks to ChartOfTheDay.com for another seemingly simple chart that evoked great discussion. This article could be called a “macro view” as opposed to bottoms-up earnings potential analysis company by company. I believe this “micro view” has more merit, but the long-term trend analysis does add an element of perspective for me.
Disclosure: No positions.