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.


  1. 50% earnings of the S&P comes from outside the US. The GDP used for comparison should probably be some global GDP metric weighted in proportion (and these weights would have changed over time).

  2. Also, does the area between the GDP and earnings/dividend number have to be equal over some period of time? If that's the case, are we ahead (GDP>E-D) or behind?

  3. As for #1, that has been an argument for years, but in the end there are other arguments against the sustainability of US corporations being able to maintain their level of foreign earnings relative to foreign corporations. Will be interesting to see.

    I get point #2 and I don't have an answer. Is the current earnings spike a "make-up" of the earnings missed in the downturn? Is the spike due to the struggle in smaller businesses, thus corporations taking a larger share with less competition?

    All good questions, but based on history and the current level of operating margins due to the lack of re-investment, I personally don't think margins are sustainable. The question (to me) is whether top line growth can make up for it.