There's no denying it, regardless of what you think of the U.S. recovery since mid 2009, corporate profits have been stellar. In fact the latest quarter set a new record for S&P 500 Operating Earnings of $24.85 surpassing the previous high of $24.06 back in June 2007.
For the full year analysts are predicting S&P 500 Operating Earnings of $98.59, a record for calendar year earnings whilst FY11 is forecast at a hefty $112.67. So the logic goes that applying an average market multiple of say 14x - 15x to next year's earnings would get you to new all time highs on the S&P 500. The first problem with this kind of reasoning is that a trailing average PE is being applied to a forward earnings projection. The average forward operating earnings multiple is more like 11x - 12x. The second problem and the one I want to focus on here is the level confidence you can have in those forecasts.
Along with record profits are record profit margins. The latest quarter to June 30 shows profit margins based on S&P 500 Operating Earnings at 9.44% almost back to their record high of 9.60% reached 5 years ago. Although the above chart is a little light on historical data, the message is clear, when corporate profit margins are at historic highs subsequent market returns over the next 12 - 24 months are poor to say the least. Analysts like economists are not good at anticipating turning points in the economic cycle and thus always late to revise their forecasts. You only have to look at the chart below to confirm that last point.
In November 2007, just a couple of weeks before the official start of the great recession, those upbeat analysts were predicting $105 in Operating Earnings for 2008. When all the data was in a little more than a year later, operating earnings turned out to be $49.51, less than half that November 2007 estimate. So take note of the signal given by record profit margins and beware of putting too much faith in analysts' earnings estimates.