Time to Row, or Sail?
By John Mauldin
Aug 03, 2012

A few weeks ago, Ed Easterling and I updated the work we published almost ten years ago about secular bear and bull markets. This week I am in Maine at your once again (for the 6th time!) watching his son catch more fish than he does analyst, he annual Shadow Fed fishing trip (for those of us whose invitation to Jackson Hole keeps getting lost in the mail). Ed has graciously agreed to do another piece with me on the earnings, or business, cycle, which is different in timing than the secular stock market cycle but is part of the total warp and woof of the markets. When you combine them, you get a much clearer picture of the markets.

Earnings are a topic of great debate. At any given time, you can hear someone on TV talking about how "cheap" the market is, while the person on the next channel goes on about how expensive the market is. Today we look at the cycle of earnings, rather than a specific point in time. Let me give you a little preview. In terms of time, this earnings cycle is already longer than average, and in terms of magnitude it is projected to go to all-time highs. Which makes one want to think about whether current projections are realistic. So let's jump right in. (Note: This letter sets the Thoughts from the Frontline record for the number of charts, so it will print longer than usual, but the number of words is about average.)

Time to Row, or Sail?

In April 2007, while forecasters predicted at least two more years of increases, the first "Beyond The Horizon" article stated:

"Earnings have increased at double-digit growth rates for five consecutive years – although many agree that earnings growth may be slowing, it's beyond almost everyone's foreseeable horizon that earnings might actually experience a decline."

By the end of 2007, earnings per share (EPS) for the S&P 500 declined versus 2006.

By the end of 2008, after an 80%+ decline in reported earnings, it was beyond almost everyone's horizon that reported net earnings would recover to more than $90 per share over the subsequent several years … yet this year's forecast is now $93 and next year is expected to top $103 per share.

Since the fundamental principles of the business cycle cause history to repeat itself, a decline in EPS should not be beyond your horizon!

Currently, profit margins are cyclically high, near historical highs, and already at unsustainable levels, with projected further increases over the next two years. Beware.

A look back at history provides insights about the earnings cycle and what is considered to be normal. Despite the statistics about average earnings growth, the business cycle drives periods of surge and stall. And the stall is generally a year or two of outright retreat, rather than smoothly slower growth. As reflected in Figure 1, earnings typically grow handsomely for three to five years, and then decline for a year or two before again growing. That's usually all that it takes to restore the balance.

   Figure 1. S&P 500 Earnings Per Share   Growth: 1950–2011

This choppy, irregular pattern has endured across periods of war, technological and business innovation, political issues, and other sorts of change. Yet the business cycle is not short; it does not run its course within a year. To more accurately see the trends, we can extend the period a few years to present the cycle as a multi-year average.

Figure 2 presents the three-year average growth rate for earnings. The cycle, while still somewhat erratic, begins to show its more cyclical nature – and the tendency for it to return to a baseline growth rate.

           Figure 2. S&P 500 EPS 3-Yr. Average Growth: 1950–2011

Profits not only grow and decline in dollar terms; they also change in relation to the amount of sales that it takes to generate the profits. Described in more detail, profits are the portion of sales that companies keep after all costs and expenses. When profits are compared to sales, the resulting ratio is known as the profit margin. As economists will acknowledge, the business cycle tends to push profit margins around a base level. When the sales of all companies are consolidated together, the result is essentially gross domestic product (GDP). Therefore, the aggregate profits of all companies can be compared to GDP, as a measure of profit margins and relative profitability.

Figure 3 presents the profit margin relationship since 1929, when the data was first readily available. The relationship has not been smooth, yet it has been fairly consistent. During the Great Depression, profit margins were low and negative. That underperforming period was followed by an extended era of above-average profit margins. The average for the entire period of over eighty years from 1929 to 2011 is approximately 9%. Interestingly, the average for the first twenty-five years (1929-1953), with its extremes, also averages almost 9%.

The extremes in both directions during the early part of the last century counterbalanced each other, as would have been expected in order to achieve the "normal" average. Following 1953, the average has also been near 9%; yet with less-extreme cycles. (Note: 1953 was used as the cutoff year to reflect a twenty-five year period and to encompass all of the more extreme years during the first half of the past century.)

                 Figure 3. Pre-Tax Corporate Profits as a Percentage of GDP: 1929–2011

Today, as highlighted in Figure 4, using quarterly data, profit margins have moved well above the historical baseline near 9% and are vulnerable to being restored again toward the average. It does not necessarily have to happen immediately, as these cycles are slow-moving. It is likely, however, to be forthcoming.

                Figure 4. Pre-Tax Corporate Profits as a Percentage of GDP: Quarterly 1990–1Q2012

Analyst forecasts remain optimistic despite recent indications of weakness. As of July 31, the forecast by Standard & Poor's for this year and next year reflects continued earnings gains – to more than $103 per share. Figure 5 adds the percentage increases for the next two years to Figure 1. This puts into perspective the notion that we're supposedly on track for one of the longest runs ever of earnings increases.

                                  Figure 5. The Analysts' Forecast: S&P Outlook – Percentages

How can we put the level of earnings into perspective? There are two methods to normalize earnings described in Ed's most recent book, Probable Outcomes. The first is a method popularized by Robert Shiller at Yale and the other is a methodology used by Crestmont Research. The blue line in Figure 6 is actual reported EPS; the red line extension is S&P's forecast. The orange and purple lines are baseline normalized EPS using Crestmont's & Shiller's methodologies.

As reflected in Figure 6, both methods reflect similar results over time. Most noteworthy in this chart is the high degree of variability for reported earnings in relation to the normalized measures. This chart is probably one of the the best ones by which to appreciate the high degree of fluctuation for reported earnings across business cycles.

                                      Figure 6. The Analysts' Forecast: S&P Outlook – Dollars

Note in Figure 6 that the current and forecast levels of earnings are becoming quite elevated above the normalized growth baseline. This is another indication that profit margins have become extreme. But how extreme?

Figure 7 presents the percentage difference between actual and forecast reported earnings compared to Crestmont's measure of normalized earnings. This enables us to see the relative difference as a percentage. That makes the chart comparable over longer periods of time when the actual dollar level of earnings is increasing. Two yellow bands are included on the chart to mark the middle 80% and outlying 10% of the points on each side of the middle. Most of all, the chart highlights just how far beyond the normal range we have currently gone and are forecast to go. By the end of next year, we're expected to be 40% above the normalized level of earnings. And since the trend tends to overshoot the baseline, the potential decline in reported earnings will certainly surprise a lot of analysts (but no longer will it surprise our readers!). Therefore, the current position in the earnings cycle is extended not only in terms of duration, but also in magnitude.

                                        Figure 7. Magnitude of EPS Over/Under Baseline Trend

Although the two methods for presenting profit margins in the business cycle are not directly comparable, we can overlay the information for some level of additional perspective. There are few well-followed forecasts for national profit margins. Figure 8 depicts national corporate profits, with a pro forma extension using the S&P 500 forecast for reported earnings growth in 2012 and 2013.

The press is now filled with stories about record profit margins. It's clear that the current record goes back a long way. This, of course, means that there's quite a long ways to fall, too.

                                                              Figure 8. Comparable Profit Margin Analysis

What about the duration of earnings cycles? Past EPS cycles have lasted one to six years. Over the past six decades, there have been twelve up-cycles. Six lasted one or two years (last year, 2011, was year three of the current cycle). We're now in the second half of the game. As each upcoming year passes with an increase in EPS, the likelihood rises for the next decline in EPS … and potentially the stock market.

Conclusion #1: Reported earnings, based on history, should be expected to decline over the next two years (or they are increasingly likely to disappoint current expectations). That will put pressure on the stock market. If history is a guide, and if the blue line in Figure 8 only slightly retreats below the historical baseline, the implication is a decline in reported EPS of almost 40%! While growth could continue (as it has done in the past), it is clear that this cycle is getting a little weathered. And note that almost every downturn came as a surprise to the markets. Any analyst suggesting a downturn is labeled doom and gloom (as we can attest).

Conclusion #2: The measures of P/E that are based upon reported EPS are currently distorted by the business cycle. Whereas current reports have the market's forward P/E near 13, a more rational measure for P/E based upon normalized baseline EPS is close to 20. P/E is not below average and is not ready to propel the market upward; it is well above average.

Figure 9 highlights the duration of EPS cycles. The chart will not include the current cycle until it is complete. Of the twelve up-cycles, half of them ended after one or two years of rising earnings. None of them exceeded six years, and only one went that long. Since 2011 was the third year of earnings gains for the current cycle, the likelihood of a decline is increasing. If a decline happens to not occur during the coming two years, then we'll make history.

When declines have occurred in the past, they most often lasted only one year. But just under half of the time, the decline extended for two or three years. Given how far this cycle has extended in magnitude, it's unclear whether the next decline will be a brisk annual event or a torturous few years.

                                                                             Figure 9. Duration of EPS Cycles

A Few Implications

The stock market and earnings analysts do not expect a decline in EPS over the next few years. The forecasts too often anchor on the recent past and extrapolate (in a burst of hope) current trends well into the future.

A broader view of history tells a different story. It is a story of a frequently erratic earnings cycle. The current cycle is now extended not only in duration but also in magnitude. It's hard to deny that EPS is vulnerable to decline over the next few years.

When the decline in earnings occurs, it will not be minimal. The decline to the historical average would be 30% to 40%. These cycles, however, rarely stop at average. More often, they move well above and below the long-term trend line.

We've all seen that the stock market reacts to surprises quite negatively. There is no reason why investors should walk blindly into this storm. "Who knew?" will not a reasonable excuse.

Active portfolio management can position portfolios to participate in further upside until the downturn occurs, then it can provide protection from the full brunt of the ensuing losses.

Some people will read the outlook for a decline in earnings to portend a recession, but earnings declines happen much more frequently than recessions. The business cycle is distinct from the economic cycle. As reflected in Figure 10, over one-third of the past 61 years have seen EPS declines despite growth in the economy. So, don't be surprised that EPS might decline in spite of continued economic growth.

                                                      Figure 10. EPS Downturns Without Recessions

A weak economy, however, adds to the pressure on earnings. The typical vulnerability at this level in the cycle is accentuated by the external forces of the economy. That makes the risks particularly worrisome.

It's Time to Think About Absolute Returns

As described in chapter 10 of Probable Outcomes and chapters 9 and 10 of Unexpected Returns, the goal is to use absolute return-oriented "rowing" investments rather than more passive relative return "sailing" strategies. Although the stock market will provide shorter-term periods of solid returns over the next decade, it will also have offsetting periods of declines. Unlike secular bull markets, where the upswings far outweigh the downdrafts, the current environment is set for a much more modest (and likely disappointing) result. Rather than acquiesce to the mediocre returns on the horizon, investors can take action and develop their portfolios to profit regardless of the overall market direction. Although market timing may be an option for some, it is generally not a good option for most investors.

Conclusions About the Earnings Cycle

The business cycle has endured for well more than a century. It generally delivers two to five years of above-average EPS growth before experiencing a year or two of pullback. We have had a dramatic run over the past two years, and the forecast for the next two years now positions profits well above their historical relationship to the economy.

Several factors now indicate that a period of EPS decline may be upon us. It does not necessarily portend a decline in the market, although that vulnerability clearly exists. Beware nonetheless! For investors, this means that portfolios should be positioned through diversification and active risk and return management.

As an analogy, winter is not a time for gardeners to hibernate; rather it's a time for different crops and techniques. Today's investors have many tools available that let them actively "row" and invest like institutions, thereby achieving relatively consistent returns with a lot less disappointment risk.

Ed Easterling is the author of the recently released Probable Outcomes: Secular Stock Market Insights and the award-winning Unexpected Returns: Understanding Secular Stock Market Cycles. Further, he is President of Crestmont Research, an investment management and research firm, and a Senior Fellow with the Alternative Investment Center at SMU's Cox School of Business, where he previously served on the adjunct faculty and taught the course on alternative investments and hedge funds for MBA students. Mr. Easterling publishes provocative research and graphical analyses on the financial markets at www.CrestmontResearch.com.

In the meantime, I still look for alternatives to a buy and hold strategy for the general stock market. That strategy is an exercise in futility in a secular bear (but will become a thing of beauty when the cycle turns). In today's world there are lots of options for the serious investor and student of the market. Rather than trying to beat the market, my benchmark today is a T-bill. How much can we make over the returns of a short-term treasury, with an appropriate plan for safety and liquidity?

Bonds, real estate, income-oriented investments, arbitrage, alternative funds, and their kin are all options. I find the obsessive focus with the stock market a real oddity, somewhat akin to giving a full company of soldiers only one gun, or bringing a knife to a gunfight. It's a strategy, but not a winning one. As I close this letter, let me refer you to a new paper by my partners at Altegris Investments, called "The Case for Liquid Alternatives," which you can find at www.altegris.com.

John Mauldin

Copyright 2012 John Mauldin. All Rights Reserved.

One Money, (Too) Many Markets

Hans-Helmut Kotz

03 August 2012


FRANKFURTEurope’s monetary union is screeching toward the abyss, unintentionally, but apparently inexorably. Greece will most likely not meet the criteria to receive further financial assistance from its eurozone partners and the International Monetary Fund. Europeans will then need to decide whether to let Greece go. The exit option would not improve Greece’s chances of successful adjustment, and it would come at a steep price for the eurozone: it would bein the money” – and priced accordingly.

A Greek exit could, one hopes, be managed. The European Central Bank would contain the collateral damage by flooding Europe’sbanking system with liquidity (against subpar collateral). Or it will reluctantly re-launch its purchases of public-sector debt in secondary markets, capping the other peripheral eurozone economies’ interest-rate spreads relative to the core.

Thus, dire circumstances would once again force the ECB’s hand. As the strongest European institution, it is systematically vulnerable to being taken hostage, compelled to underwrite a further lease on life for the euro. In this light, ECB President Mario Draghi’s recent vow to dowhatever it takes” to save the euro came as no surprise.

Back in 1999, it seemed that Jacques Rueff, an adviser to Charles de Gaulle, had been vindicated: L’Europe se fera par la monnaie. Eleven European countries chose to give up their national currencies (or, more technically, the nominal exchange rate).

These countries understoodone money” as a quasi-physical corollary of “one market.” Independent national monetary policies in a common market were rightly seen as infeasible, given Europeans’ preference for stable exchange rates and open financial markets. This called for a single currency – and thus shared responsibility for monetary policy.

Today, however, we may need to re-phrase Rueff’s axiom: Et l’Europe se défait par les marchés financiers, unless, that is, Europe comes up with a viable institutional design.

Given the euro’s current travails, it is instructive to recall arguments stressed in the run-up to monetary union. As the Nobel laureate economist Robert Mundell and others spelled out in the 1960’s, relinquishing nominal exchange rates emphasizes three alternative mechanisms to cushion regional adjustment: inter-regional fiscal transfers, intra-union migration, and, most importantly, labor markets capable of adapting to shocks.

Unfortunately, these mechanisms were anathema at the time. Conveying the message that nothing would have to change appeared to be far more attractive.Thus, Mundellian arguments were not heeded when the euro’s institutional blueprint was conceived. Indeed, the Stability and Growth Pact, like Europe’s no-bail out clause, ignored the pertinent economic theory (some say any economic theory).

Regional current-account balances were interpreted as the upshot of infallible optimizing behavior by market participants, rather than, for example, the result of a real-estate bubble in Spain and elsewhere.

Only after the fact, since the fall of 2009, has it become conventional wisdom that those intra-union current-account deficits, accumulating over a decade, were untenable. Now, given monetary union, the adjustment must be carried out by changing domestic prices relative to tradable goods – that is, by engineering a depreciation of the real exchange rate.

In view of the quite substantial overvaluation in some periphery countries, this will be a time-consuming process. (Germany needed almost a decade to adapt to a smaller property bubble in its new eastern Länder in the early 1990’s.) But it is difficult to imagine that market participants will have the required patience. That is why supporting the euro requires forceful and credible crisis containmentwhatever it takes.


But the ongoing crisis also highlights a second design flaw, unacknowledged in Mundell’s argument: the challenges arising from integrated financial markets (including those for the credibility of the no-bail out clause). Under normal circumstances, unimpeded cross-border capital flows come with all of the advertised benefits in terms of better resource allocation and higher productivity. In the wake of the crisis, however, given the shared fate of national governments and banks, a significant home-bias re-emerged. Ring-fencing became national supervisors’ default option, and monetary conditions became re-segmented along national lines.

This translates into a significant disparity in financial institutions’ funding costs. The immediate upshot is a substantial divergence in firms’ cost of funds, with many small and medium-size enterprises even losing access to credit completely. As a result, capital expenditure – already a fragile proposition, given weak demand – has plummeted, triggering a vicious circle of shrinking GDP, lower tax revenues, higher expenditures, and further destabilization of public-debt positions.


The problem is not only that such heterogeneity in funding conditions renders a common monetary policy difficult to conduct. More important, given that some regions now face interest-rate spreads that are the functional equivalent of having their own currencies (without a central bank), some eurozone members might at some point wonder why they should not formalize what is de facto a reality. Market participants already do, to a degree.

None of this is inevitable. The euro was not created for purely economic reasons. If it is deemed a worthwhile project, and is viewed as mutually beneficial to all participants, the eurozone could be made viable. In order to achieve this, certain minimum conditions must be met. In addition to flexible labor markets, a viable eurozone presupposes a (minimal) fiscal insurance mechanism. And it calls for not only common financial regulation, but also for eurozone-wide supervision of financial institutions, including common deposit insurance and a shared bank-resolution scheme.

This is a tall order. And it will take time to implement. But the immediate short-run alternativeletting Greece (and potentially others) fall by the wayside – would carry a substantial price.

Periphery countries would be forced to pay a significant premium to compensate investors for assuming a redenomination (partial default) risk. And, with that, the eurozone would become as vulnerable as any fixed exchange-rate system has historically proven to be.

Hans-Helmut Kotz, a senior fellow at the Center for Financial Studies, Goethe University, Frankfurt, and a resident faculty associate of Harvard University’s Center for European Studies, was a member of the board of Deutsche Bundesbank from 2002 to 2010, in charge of financial stability, markets, and statistics.