Monday, August 23, 2010

Are Corporate Earnings Sustainable?

Last week, EconomPic showed the historically relationship between the treasury yield and nominal GDP growth. Below, we compare corporate earnings growth to the treasury yield over that same ten year window.

What we see is that earnings on a cyclically adjusted basis (smoothed per Shiller) have been growing faster than the broader economy for the past ten years.

My thoughts (as shared last month):
The important question is how these earnings have come about. We all know that recent earnings have ratcheted higher due to reduced costs (job cuts, lack of investment, cheap financing) rather than top line growth. In other words, executives for public firms have caught up with the "buy, strip, and flip" nature of private investors.
In addition, simple math proves that earnings cannot grow faster than nominal growth over the long term, as that would imply earnings at some point become larger than the economy as a whole (not possible as earnings are part of the economy).

In summary... expect earnings to be under pressure in the not too distant future unless there is surprise outsized rebound in the economy.

Source: Irrational Exuberance