Photo: St. Louis Fed
Over the long haul, stocks tend to gravitate around earnings.Earnings, meanwhile, tend to gravitate around revenue–which is to say, corporate earnings average about 6% of corporate revenue and move in a range between 4%-8% of revenue, depending on where we are in the business cycle.
Right now, earnings are at about 8% of revenue–the top of the range.
Always before, when earnings have hit this level of revenue, they have soon plunged–back to the average of 6% of revenue or far below it.
Today’s analysts are not predicting that earnings will plunge as a percentage of revenue.
On the contrary.
Analysts are predicting that earnings will continue to rise as a percentage of revenue over the next two years, reaching levels that have never before been seen in the recent history of economics (and, possibly, ever).
Check out this chart from GMO’s James Montier that shows this consensual hallucination:
Photo: GMO LLC
And these earnings projections form the basis for the bullish-as-ever stock market calls of most major market strategists.
Do the strategists offer compelling explanations for why they’re expecting profit margins to do something they have never done before?
They just assume that earnings will do what they generally do and have done for the last few years–grow.
So, as you finally start to get comfortable with the idea that all that bad stuff is behind us and stocks will now just keep going up, ask yourself this simple question:
Which is more likely?
- Over the next couple of years, profit margins will just keep on rising to levels that have never been seen before
- Analysts are, once again, wrong