The Earnings Boom

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If the economy's limping along, you'd never know it by looking at earnings estimates.

Forecasts for the S&P 500 call for the index to earn $98 this year and $112 next year. That's up from $84 in 2010, and $87 during the last peak in 2006. Put those numbers against an S&P trading well under 1,300, and you see why plenty of investors think stocks are cheap. We're talking 13 times forward earnings.  

But put those numbers against 9% unemployment, slowing gross domestic product growth, declining housing prices, and more than $14 trillion in national debt, and you can see why citing analyst estimates are often famous last words.

So who's right? The bulls or the skeptics?           

Let's talk for a second about bubbles.

There are two types of bubbles that lead to big losses.

The first is a valuation bubble. Stocks with no earnings trading at 100 times sales are in a valuation bubble. The late 1990s was a valuation bubble. LinkedIn (Nasdaq: LNKD  ) the day it went public was a valuation bubble.

The second is a little more tricky. It's an earnings bubble. In an earnings bubble, valuations look good, but how a company makes money is unsustainable. The best example is banks last decade. Even at the top of the housing boom, banks like Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) traded at reasonable multiples of earnings and paid solid dividends. It was how they earned money that was outrageously out of whack.

When you look at S&P earnings today, the biggest risk is that we're in the latter -- an earnings bubble. Or maybe not a bubble, but a cyclical peak. As Fool Alex Dumortier showed last year, corporate profits as a percentage of GDP are solidly above average. Corporate profit margins are also at an 18-year high. Both of these tend to be mean-reverting and give ammo to the skeptics. It's hard to expect profits to keep growing when, by almost any measure, they're already so high. This is a valid worry that shouldn't be overlooked.

But there are counterpoints, too.

Many wonder how earnings can be so high when the economy is so low. Nine percent unemployment and record corporate profits is a puzzle, particularly for an economy driven overwhelmingly by consumer spending.

But the 9% unemployment figure we throw around can be misleading. During the Great Depression, someone who lived through it recently told me, no one had money. Everyone was hurting. (An exaggeration, but only slightly.) It's not like that today. Ten percent, maybe 20%, of the economy is hurting mightily, but for a large portion -- maybe half the economy -- today is as good as it's ever been. It's pure bifurcation. If you're an unemployed carpenter underwater on your home in Las Vegas, it's bad. If you're a software engineer in Silicon Valley, you're turning down job offers left and right and basking in raises. Media headlines focus almost entirely on the former, but the strength of the latter has been enough to push consumer spending to record heights. That earnings have followed isn't surprising.

Something else to consider is how global the S&P 500 is. Ten years ago, less than a third of S&P revenue came from overseas. Today it's nearly half and growing. It's also where essentially all the growth lies. Coca-Cola (NYSE: KO  ) and Intel (Nasdaq: INTC  ) do the large majority of their business abroad. Companies such as Wal-Mart (NYSE: WMT  ) are U.S.-centric, but gain essentially all their growth overseas. Yet analysts and commentators laser-focus their attention on the U.S. economy when guessing where earnings are heading. Why? A tepid U.S. economy coupled with solid growth from Asia and South America will drive profits higher. And that's about what's happening now.

Finally, productivity growth is still high as companies remember how to be efficient after the 2008-2009 meltdown. Redundant workers are gone. Cost-saving technology is flooding in. That sets up a lopsided trade-off between employees and shareholders, as Felix Salmon noted this week: "When unemployment is low, productivity gains go to labor," he wrote. "When unemployment is high, they go to capital."

Could the strong 50%-60% of the economy turn south? Of course. Could China's growth hit a wall? Absolutely. Could the tide shift from capital to labor? Yes. There are no guarantees the earnings boom will continue. But if I had to bet, I'd say it's the real deal. The biggest irony of the deepest U.S. recession in generations is that corporations quickly became stronger than ever.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.   

Fool contributor Morgan Housel owns Wal-Mart and B of A preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Coca-Cola and Wal-Mart Stores. The Fool owns shares of and has bought calls on Intel. The Fool owns shares of and has opened a short position on Bank of America. Motley Fool newsletter services have recommended buying shares of Wal-Mart Stores, Intel, and Coca-Cola. Motley Fool newsletter services have recommended creating a diagonal call position in Intel. Motley Fool newsletter services have recommended creating a diagonal call position in Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (19) | Recommend This Article (53)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 24, 2011, at 3:42 PM, kenolds wrote:

    I forget where I read it, but the gist was this: If earnings are really that good and not just an accounting trick, why aren't dividend payments rising?

  • Report this Comment On June 24, 2011, at 5:44 PM, CashRulez wrote:

    Good point Ken...brings up another issue of corporations hoarding their cash. It's great to plan for a double-dip or another crisis, but how much cash is too much?

  • Report this Comment On June 24, 2011, at 7:25 PM, Pazzel wrote:


    Dividend payments arent rising because companies are uncertain about the future. As long as a huge source of consumption is due to quantitative easing, its in a company's best interests to hold onto its cash. They arent hiring either nor are they investing in anything remotely risky, such as a major expansion.

    They laid off 20% of their workforce... the least productive 20%. They are operating more efficiently than ever and there is more money being thrown around than ever. Government is printing it like crazy. Just recently we saw even more government intervention (strategic oil reserve).

    Its good news, kind of, as long as its sustainable. Since its not, most companies will play it safe and hold onto their cash.

    At some point, the economic future will become more predictable and less reliant on government policy, and we will see that pile of cash go wild with dividends, buy backs, hiring, and expansion.

  • Report this Comment On June 24, 2011, at 7:43 PM, Borbality wrote:

    why raise dividend payments if investors aren't going to leave your stocks anyway? where are they going to go? bonds? come on. they'll raise their dividends if other investments get attractive enough to pull significant investors away. they're not giving dividends away as charity!

  • Report this Comment On June 24, 2011, at 8:49 PM, TMFTypeoh wrote:

    Morgan, all your articles are outstanding. Terrific points across the board. Well done!

  • Report this Comment On June 25, 2011, at 5:49 AM, JaneBond wrote:

    "They laid off 20% of their workforce... the least productive 20%. "

    That's not necessarily true, at all. The top of the food chain, is not necessarily the most productive. We'll see what happens when their prey runs in short supply.

  • Report this Comment On June 25, 2011, at 7:59 AM, Travlinmo wrote:

    I agree with the easing being a portion of why the hiring and expansion is slow. I also think the games congress is playing with debt are probably inhibiting all kinds of moves. Would you hire with congressman standing out to essentially say they intend to bankrupt the most secure bonds on earth? No one believes they will do it, but why make a move until you know they didn't.

  • Report this Comment On June 25, 2011, at 9:16 AM, skypilot2005 wrote:

    Morgan wrote:

    "Many wonder how earnings can be so high when the economy is so low. Nine percent unemployment and record corporate profits is a puzzle, particularly for an economy driven overwhelmingly by consumer spending."

    I suspect Morgan will refute this and site a couple recent “surveys” but I feel the upcoming implementation of Obama Care is having an effect on our unemployment %. Therefore, I feel it is a factor in the “disconnect” between profits and hiring.

    McKinsey just completed a survey of a cross-section of businesses of many sizes across industries and regions. After reviewing the survey, The Wall Street Journal contends in an article Thursday titled: Shutting Up McKinsey:

    Health Care represents over 17% of our economy.

    “As more people partake of free health care, taxpayers costs will explode.”

    The WSJ concludes:

    “The fact that the White house feels it must vilify businesses for telling the truth about ObamaCare shows just how destructive the law really is.”

    Many business decision makers may agree.

    This may explain part of the “disconnect” between company profits and our high unemployment rate if, business decision makers feel the same way as this relates to the their view of the future of our macro economy.

    I am sure the decision makers’ perception of the effect the law will have on their bottom line also, plays a part. Whether or not that perception is accurate. To say the least, it is a controversial topic.

    I believe it is part of the “puzzle”.

    Sky Pilot

  • Report this Comment On June 25, 2011, at 1:30 PM, Sparkynet wrote:

    Another fine article by Mr. Housel. I think it's a good bet that earnings will continue to be good. However, after what happened to ORCL on Friday, I don't know that it will necessarily lead to stock price appreciation. There just seems to be so many headwinds right now. Now that the big banks know they are too big to fail and will get bailed out, who's to say they aren't working on the next crises? After all, the last one earned them some fantastic bonuses.

  • Report this Comment On June 26, 2011, at 1:23 PM, Jazzenjohn1 wrote:

    Great article!

    I tend to think we have come up against a few stalemates. We're giving out unemployment with no end in sight, so for someone who can get a job at less than he had been earning or continue with unemployment and work under the table the choice is clear. I believe we should begin reducing unemployment benefits going forward.

    Banks can borrow free and invest in treasuries and other debt with low risk, why give anyone without perfect credit a loan at todays low rates when the alternative is better? I believe the answer is to slow the tap to banks and begin raising rates. The overhang on housing should be dealt with by an incentive for commercial buyers. There is going to be more renting and there is little reason to stop it from happening.

    Companies should give more dividends but they don't have much reason to do it and shareholders have little say in the matter. It should be considered how much of the companies extra cash is overseas, and their desire for a tax holiday to bring it home. The last time we did this the money did absolutely nothing to increase employment or investment here, in fact there was an increase in offshore outsourcing after it happened. Yet another stalemate.

  • Report this Comment On June 26, 2011, at 9:28 PM, fredgei wrote:

    skypilot2005 wrote:

    "McKinsey just completed a survey of a cross-section of businesses of many sizes across industries and regions."

    That McKinsey "survey" was a push poll, the sort that "educates" recipients toward a desired conclusion. It also reached the opposite conclusion of their very own medical economics analyst. Given that the poll was conducted by their political consulting division, this does not greatly surprise me.

    Having said that, is health care reform having an effect? Probably. For the same reason that equally groundless claims that Obama was coming after America's guns greatly increased gun and ammunition sales. Let's face it: Terrorizing the gullible is one of our growth industries.

  • Report this Comment On June 27, 2011, at 6:51 AM, skypilot2005 wrote:

    On June 26, 2011, at 9:28 PM, fredgei wrote:

    "That McKinsey "survey" was a push poll, the sort that "educates" recipients toward a desired conclusion."

    That's your contention. I'll go with the opinion of the WSJ and the survey McKinsey used. It was "rigorous" according to the WSJ.

    On June 26, 2011, at 9:28 PM, fredgei wrote:

    "Having said that, is health care reform having an effect? Probably."

    That's the only point I was trying to make.

    I feel Obama Care MAY be a positive for small businesses and by the number of companies "opting out", it MAY be a negative for some large corporations.

    It needs to be specifically measured in any evaluation of why companies aren't hiring. To not do that is like one sticking their head in the sand.

    Sky Pilot

  • Report this Comment On June 27, 2011, at 7:00 AM, skypilot2005 wrote:

    On June 26, 2011, at 9:28 PM, fredgei wrote:

    "That McKinsey "survey" was a push poll, the sort that "educates" recipients toward a desired conclusion."

    I’ll let the reader decide who is credible:

    Here’s a link to the piece:

    Shutting Up McKinsey

    Fool On.

    Sky Pilot

  • Report this Comment On June 27, 2011, at 7:20 AM, JeanDavid wrote:

    "They laid off 20% of their workforce... the least productive 20%."

    I used to work for a large regulated monopoly. At some point, some of the regulations were relaxed, in part because we split up into a regulated part and an unregulated part. But management did not appreciate what they had done and found they did not want to pay the number of employees they had. They did not want to lay the employees off or fire them because their unemployment insurance premiums would increase. So they tried to get employees to resign by offering a string of incentive plans. And they worked to a certain extent. But far from getting rid of the 20% least produtive, these plans amounted to a dead wood retention program. All thouse highly qualified people, who knew they would have no trouble getting another job took the incentives and resigned. And those who could not, or feared they could not, get a better job remained. The plan I took got rid of 14,000 or so people. The company wanted to get rid of 20,000 people. But another funny thing about these programs is that getting rid of 10,000 people, or 14,000 people, or whatever, the number of employees did not seem to go down. More paper pushers were hired. People were hired to replace those who departed. The new people were paid less, but they did not know the scientific or technical culture of the business. In 10 or so years, this company went out of business after being in business over 100 years.

    In our case, we laid off the most productive 20%, though I do not know if that was the intention or not.

  • Report this Comment On June 27, 2011, at 12:49 PM, plange01 wrote:

    a failing leaderless america is in talks to give china alaska and hawaii as collateral for its incredible debt to them....

  • Report this Comment On June 27, 2011, at 2:11 PM, pastreet wrote:

    I'd love to see those dividend payouts begin to rise again...


  • Report this Comment On June 28, 2011, at 3:08 PM, FutureMonkey wrote:

    I've been re-reading Ed Easterling's Unexpected Returns prior to sitting down to his new book. Also check the updates on the Crestmont Research site periodically to look at the big macro trends. Seems we may still be in a long secular bear market and have been since 2000. Even though SP500 dollar value is going up in most of the last 11 years, its in going up more slowly than earnings. Typical secular bear markets end until we are well below historic averages not just back to historic average. We reached that point during the market lows in 2008, but seems that earnings are still outpacing what the market is willing to pay for those earnings. I'm optimistic for the future and am happy to keep swimming through the choppy waters.

  • Report this Comment On July 01, 2011, at 6:53 PM, fppjr wrote:

    Everyone should know the reason for our eco. problems was the free for all in which the banks took part.

    Most will not acknowledge that if the Sherman Anti-trust Act had been applied when all these businesses were getting "TOO BIG TO LET FAIL" then only sectors of the economy would have suffered dearly and very likely recovered already.

    Unfortunately, business is treated in the same way war is treated, when you have "war-hawks" wanting a big war and the counter people saying, "LOVE NOT WAR"; but what wins out is who is going to make the most money, while the people on the whole have to suffer.

  • Report this Comment On July 03, 2011, at 2:24 PM, bruce4guns wrote:

    9% unemployment, really!! Please take into consideration how that number is arrived at. If you have ceased looking because there are no jobs you are not counted. If you owned a business that is now no longer you cannot get unemployment in most states and you are not counted. If you used to make $200k and are now driving a limo earning $30k while you look for a new gig you are not counted. Real unemployment and underemployment is probably double that 9% fictitious number.

    QE2 is over, we can't afford a QE3 and Government is going to be forced to live within it's means either because it wakes up or the rest of the world won't support the binge. The easy money days are quickly dissappering.

    He who has the gold makes the rules they say .This is why you will continue to see business hoard cash and not raise dividends.

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