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Thursday, December 30, 2010

Are Earnings Stretched?

The chart below shows the long-term relationship between S&P earnings + dividends and nominal GDP growth. The dotted lines represent the 90 year average and shows earnings + dividends have grown ~2% less than nominal GDP. Not surprising, nominal GDP grows faster on average (otherwise earnings would eventually become larger than GDP, which is not possible).

What this does show is that earnings growth over the past 20 years is above GDP growth, showing how stretched earnings (via record wide margins) are. The risk for equity investors is that this relationship normalizes and earnings growth revert back its historic 1.5% - 2% below nominal GDP trend.

See my previous post Earnings Jump... Cause for a Concern? for some additional thoughts on why current earnings are likely unsustainable.