Please ensure Javascript is enabled for purposes of website accessibility

The Earnings Boom

By Morgan Housel - Updated Nov 7, 2016 at 7:32PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

How long can it last?

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.

None

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Wal-Mart Stores, Inc. Stock Quote
Wal-Mart Stores, Inc.
WMT
$126.58 (0.80%) $1.01
Citigroup Inc. Stock Quote
Citigroup Inc.
C
$51.66 (0.78%) $0.40
Bank of America Corporation Stock Quote
Bank of America Corporation
BAC
$33.96 (1.68%) $0.56
The Coca-Cola Company Stock Quote
The Coca-Cola Company
KO
$63.38 (-0.46%) $0.29
Intel Corporation Stock Quote
Intel Corporation
INTC
$35.39 (-0.76%) $0.27

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
377%
 
S&P 500 Returns
123%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 08/07/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.