Earnings & The Stock Market

The current cyclical recovery in corp. profits has been very powerful
so far. In history, it has only been matched by the massive jumps in
profits that occurred in the post WW1 economic recovery, the
surge off the Great Depression bottom in 1932, the immediate
post WW2 recovery and the great bounce after the 1937 recession.
The current surge in profits has exceeded most observers' initial
estimates by a country mile.

Grand surges in profits off depressed levels as recoveries begin can
last up to four years and fool more conservative expectations. It is
absolutely true that the exceptional earnings recovery over the past
year has been in part fueled by cost cutting, but yr/yr sales are up
about 9.5% by my count. The sales have provided the leverage
needed to produce the profit gains, and it is critical to note that
most companies have achieved recovering sales with just nominal
purchasing power. Plus, we can throw on about $200 bil. of loan
loss reserves that pared the total figure.

Let me stir the pot a little bit more. The bookend recessions of the
past decade have led to a large output gap between sales as booked
and sales that would have been booked under more normal trend
progress conditions. For SP 500 profits that "gap" is about $30 per
share or 42% of 12 months profits through July. History shows that
when a large output gap opens up in the wake of very poor economic
performance, only a portion of it is made back with the rest lost to
history. Even so, there is latent profits recovery of consequence in
store.

Most agree there is a slowdown of output growth ahead, and as I
discussed yesterday there is uncertainty over the likely progress of
liquidity growth needed to sustain economic recovery. When you
contrast this line of thought with the fact that profits have been
exploding upward, I think you will find a situation where without a
very sharp and extended slowdown in output growth, profits could
continue to run strong even if there is only a modest acceleration
in the growth of pricing power as economic recovery progresses.

And, you can see this tension playing out in the financial media.
Earnings are popping, but macro data suggests a slowdown ahead.
Now, even if profits growth goes ahead and moderates sharply, we
may well wind up with 12 month earning power for the Sp 500 at
decently high levels -- say $80 to 85 a share -- with much more
to come when the slowdown ends and the economy steps up some
in growth.

I guess if you pool today's post with yesterday's, what may shake out
is risk / uncertainty in the short run for stocks vs. the potential for
a big pay day if the economy regains moderate balance.

Ah, well, something to think about.