Fiscal stimulus may be in the driver's seat. While monetary stimulus and QE gets credit for driving the bull market, it may actually be the lagged effect of fiscal stimulus. If so, earnings should have dismal or declining growth.
The chart below shows annual operating earnings of the S&P 500 in black and the Federal budget deficit as a percent of GDP in red. The deficit is inverted and leading 29 months to show its lagged stimulative effect on earnings. Big deficits appear to correspond with strong earnings about 2 years later.
(click to enlarge)The increase in the deficit from about 1.5% of GDP in 2006 to about 10% in 2009 corresponds with the dramatic increase of earnings from the bottom of the great recession into 2012. The flattening out of earnings growth since 2012 corresponds with the budget deficit stabilizing. The improvement in the budget the last two years may imply falling earnings going forward.
The chart above is shown as a linear correlation which works OK for the time period from 2000 forward. However, going further back the correlation is better shown by de-trending both data series. The black line in the chart below is the annual change in earnings while the red line is the annual difference in the percent of GDP. So for example, the last point on the red line plotted at 3.1 is the difference between the deficit of 4% in the second quarter and the deficit of 7.1% in the second quarter of 2012.
The last point for annual earnings growth is 0.6% for the second quarter. If I were to include the current S&P estimate for the third quarter with about 26% of companies reporting the annual growth rate would be 4.6%. Official estimates for the next 4 quarters suggest earnings will grow 15% over the next year.
While the deficit is still a larger percent of GDP than about 75% of our history the improvement over the last year is the strongest improvement since the mid 1970s. The declining fiscal stimulus should be a headwind to earnings growth going forward.
Operating earnings have only been officially reported since 1988. In that time period the best fit growth rate has been 6.5%, shown in green in the chart below. The chart also shows "As Reported" earnings in black.
In the short term operating earnings track what happens better in a company than as reported earnings. Operating earnings give a better picture of the ongoing operations of a business and are less volatile than as reported earnings. However, the widening gap between operating and as reported earnings suggest that companies are finding ways to exclude a growing share of expenses from operating earnings that occur and still show up in as reported earnings. The growing gap is most obvious during recessions, but it is also true that at the peak earnings in each business cycle the gap between the two measures has been larger than at the peak in the previous cycle. This probably means operating earnings have an increasingly bullish bias. If so, a PE using today's operating earnings does not give an apples to apples comparison of value with a PE using operating earnings from 1988 and certainly would not give a true comparison to a PE using as reported earnings prior to 1988.
As reported earnings started with the S&P 500 index back in 1957. Cowles and Associates used the methodology of the S&P 500 (SPY) to estimate as reported earnings and the stock index back to 1871. Here are those earnings adjusted for inflation.
Here is a look at the annual change in real as reported earnings compared to the change in the budget deficit.
We appear to be in the part of the business cycle where earnings will grow below trend if not start declining. While earnings could easily have a quarter or two that sends the annual growth rate up, this would likely be a blip followed by negative earnings growth. Official S&P Statistical Service estimates that earnings will grow at 15%, more than 2 times the average historical rate, over the next year and a half.
In the beginning of an economic recovery/expansion it is normal for earnings to grow at several times the historical pace. Four years into a recovery/expansion when real as reported earnings are more than 34% above the long term trend, the norm is slower or negative earnings growth. Since 1950 earnings have only been this far above trend 9% of the time. Double digit earnings growth from here is hopelessly optimistic.
In addition to being in an unfavorable period of the business cycle for earnings growth, the trend appears to be weakening. You may have noticed in the charts above the best fit growth rate for operating earnings since 2000 is 5.2% vs. a 6.5% rate since 1988.
Perception reacting to a gap with reality contributed to the steepness of the bear markets beginning in 2000 and 2007. As earnings peaked and started down in those cycles official forward estimates were still indicating double digit earnings growth. A similar gap between perception and reality appears to be in place now. The reaction to that gap should come within weeks or at most months.
If the bull run since March 2009 has actually been driven by fiscal stimulus rather than monetary stimulus the gap between perception and reality could be exceedingly large.