Toll-free: (877) 631-6311 | Local: (602) 626-3100 |
Office Open
.(JavaScript must be enabled to view this email address)
Time to Row, or Sail?

Time to Row, or Sail?

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 John's book Bull's Eye Investing (and the recent Little Book edition) and in chapter 10 of Ed's 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 than you employ in spring or summer. And let's be certain about this: there will be a new spring, and I will turn bullish – probably too soon! – as we begin to see signs of a thaw in the markets. But for now, 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.

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 Just click on your category of investor and you will find that paper and others on alternative investments.

RIP, Darrell Cain

A few years ago I and Tiffani were having a lunch with Darrell Cain and his son, Darrell Junior. We were sitting outside on a beautiful spring day, talking about markets and savoring the easy banter that good friends can have. It was the first time for me to meet his son, a quiet and inquisitive bear of a kid who had just graduated from MIT and was in graduate school at Stanford, literally studying to be a rocket and space scientist.

Toward the end of the lunch, Darrell Senior leaned over to me and said, "John, I have to be open with you. Darrell has just been diagnosed with a very serious form of brain tumor. It can initially be fought with chemotherapy, but it always comes back and there are no survivors. We are exploring options, and I know you follow biotech. We hope to find that there is something new we can do. Do you know of any place we can look?"

I went back to the office and made a few calls, and Pat Cox directed me to a new company being formed in Cincinnati that had a potential cancer therapy. He put us in touch, and a few weeks later Darrell, Darrell Junior, and I were on a plane to see the founders and the CEO, Dr. Ray Takigiku of Bexion (

The research was very promising. There were mice studies that were actually quite exciting: researchers at Cincinnati Children's Hospital had discovered, while looking at another childhood disease, a molecule that seemingly targeted cancers of all types, and that was even able to get past the blood-brain barrier to target brain tumors. But, as my doctor, Mike Roizen, liked to tell me, orange juice works in mice. The key would be to get the process out of the laboratory and eventually to human trials. We eventually became involved with the company and have followed their work closely, hoping that young Darrell's race against time could be won.

It has not been an easy or cheap to go from the lab to the creation of a drug that would be pure enough for human use. This past month, the first vials of the drug that we hope will become the formulation for human trials came out of the production facility. If all goes well, human trials will begin in the second quarter of next year for glyomas (brain) and pancreatic cancers, and perhaps some others that the animal models suggest might be good targets.

Darrell Junior initially responded well to chemotherapy, but earlier this year the cancer returned. By the time he came to my conference this spring, he was visibly affected. Darrell took his son all over the world, trying the latest therapies in search of a cure.

Sadly, I got a text from Darrell earlier this week that young Darrell had passed away. He had been ever so hopeful. His dream was to one day go into space. I hope that he is discovering a new universe now.

We have all had these same sad moments when we lose someone to the scourge of cancer. When it is someone young it seems especially tragic. I follow a lot of companies, looking for cures with a variety of approaches. Perhaps Bexion has one of the important pieces of the puzzle, and then again, it may be another group of researchers with a totally different approach. But I sense that we are close to the time when we will no longer need to endure our loved ones coming to an untimely end to their lives.

I hope Bexion's trials work out. We should know in a few years, one way or the other. If their drug does leap from successful tests in mice to human success, I am sure it will have some new name attached to it, by which the world will know it. But to me, it will always be Darrell's Drug. Rest in peace, young man.

Maine, Home, and Carlsbad

I am in Grand Lake Stream, Maine tonight, with so many friends, at the Shadow Fed meeting put on by David Kotok, trying to finish this letter in the only place with an internet connection, which also finds me in the midst of great deal of music and laughter, with occasional comments from those looking over my shoulder – it's a tough crowd. Some of the names you already know, as I quote them so often, like David Rosenberg, Martin Barnes, Barry Ritholtz, Bill Dunkelberg, Chris Whalen, Jim Bianco, and Philippa Dunne; and there are others you would like to know. Lots of chief economists and some Fed types. There is a strong contingent of the fair sex this year, as the event is becoming more ecumenical with each passing year. Kotok puts together a very interesting crowd.

My youngest son, Trey, and I have been coming to this event for six years. He has grown up with this crowd (literally, as he added at least a foot in height over that time). It has been a most rewarding time for us. After I hit the send button I am going to forget about the world for a few days and enjoy the moment. Hopefully the fishing will get better this weekend, as today it was rather dismal. In the larger scheme of things, actually catching some poor fish is not the reason for being here, but it does make it a tad more fun. And the guides do make a great fish chowder for lunch.

I will be in Carlsbad, California at the Casey Summit, September 7-9. There is a top-notch lineup of speakers, if you can make it. (

It is time to hit the send button. The night is relatively young and the conversation out on the deck is calling. Trey and I fly back to Dallas on Monday, where I plan to be home for a few weeks (or at least that is the plan now). Next week, perhaps, we will look at the employment numbers that came out today. And at some point I might even address the political situation coming at us in the fall, which is a large topic of conversation everywhere. Speaking of politics, I got to sit next to and then hear George Will speak this week in Denver. And the governor of Maine dropped by this evening. Go figure.

Ed Easterling, my coauthor for this week's letter, wrote 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

Your once again (for the 6th time!) watching his son catch more fish than he does analyst,

John Mauldin
John Mauldin

Did someone forward this article to you?

Click here to get Thoughts from the Frontline in your inbox every Saturday.


We welcome your comments. Please comply with our Community Rules.


Bill Geer
Aug. 4, 2012, 5:02 p.m.

Good insightful article;except the less than imaginitive advice within the conclusion:  diversification/active risk - return management.. ho hum!

I agree with Mr. Tripp that these EPS’s need to be adjusted for dollar devaluation to have a much better grasp of real earnings.

And can someone explain the seemingly contradiction between the 2008 financial downturn (everyone lost money) but corporate earnings skyrockets through the roof - what’s going on here?

David Heitel
Aug. 4, 2012, 3:34 p.m.

I believe the GDP numbers are for the US only.  Since most of the SP 500 are global companies with a large percentage of profits coming from international markets, it would be interesting to see how the analysis of profits to Global GDP would compare to the analysis presented.

Josh Taylor
Aug. 4, 2012, 2:23 p.m.

Good article & charts . It would be helpful to note the growth in the earnings from non USA markets , which may contribute to a higher rate of profit compared to USA GDP

John Plodinec
Aug. 4, 2012, 2:01 p.m.

You make the point that the downswing doesn’t imply a recession.  However, given the likely size of the downswing, doesn’t that make a recession much more likely?

Gordon Foreman
Aug. 4, 2012, 1:25 p.m.

My first observation, like that of Robert Braun, is that Figure 1 shows a system oscillating out of control. If I saw a graph like this of a mechanical system, I would be reaching for the kill switch, hoping to shut it down before it breaks itself apart.

I then stopped to consider whether inflation of the dollar might be an alternative explanation, but it seems unlikely, as the scales are in % rather than $. At the same time, I suspect that the underlying cause may be related to the expansion of the money supply, over-riding the natural feedback mechanisms of the market that would normally prevent such extremes.

In any case, if modifications are not made to this system to reduce the magnitude of these oscillations, and bring it back into a more stable pattern, this graph is symptomatic of a system that is about to come apart. Given that the waves are several years in duration, this is not necessarily imminent, but it is worth noting that a machine exhibiting such behavior is most likely to fail at either peaks or troughs.

hugh owens
Aug. 4, 2012, 1:13 p.m.

John is one of the very few financial analysts who I now follow and that is because John seems to think for himself and he often ignores the nattering of the clueless and it is obvious he is skeptical about governmental statistics and prognostics which frequently are just extrapolations of current and past trends. What I would like to urge John to consider is that using past trends even as far back as the past 100-150 years as a basis for the future of economic growth is probably doomed because of future energy and commodity scarcity and costs as well as unsustainable population and pollution and global climate alterations likely brought about or at least augmented by such economic growth. Real economic growth in the face of a declining industrial profile would seem to me to be an unlikely future scenario because I think we are entering a new paradigm in which real wealth creation is declining. Fortunes may be made by the inscrutable gimmicks of financialization but true wealth creation is still absent.  There will still be money to be made on the backside of industrial decline but extrapolating from the past will not provide the clues going forward. There will be no escape for much of the world from the debt and credit debacle that it finds itself in. Growth as we have known it is likely a thing of the past. John if you feel like you have missed the economic charades of Jackson Hole, I would like to extend you an invitation to stay with us in our log guesthouse in Jackson Hole in August . I can recommend some good fishing holes and back country to hike or ride horses in. You are welcome to use my bear spray.No pun intended.

Neil Newton
Aug. 4, 2012, 12:33 p.m.

Neil Newton:  Thank you for the thoughtful summary, and I wish all the best with my friends and guides at Grand Lake Stream.  Happy to see the return to Bloomberg airways!  N. Newton, Boothbay Harbor, ME

Neil Newton
Aug. 4, 2012, 12:28 p.m.

Thank you for the thoughtful summary, and I wish all the best with my friends and guides at Grand Lake Stream.  Happy to see the return to Bloomberg airways!  N. Newton, Boothbay Harbor, ME

Rick Salant
Aug. 4, 2012, 12:27 p.m.

Very good article, none of which I knew.

One thought:  What would S&P 500 earnings be right now absent Apple’s contribution?  I think I’ve read that Apple alone accounts for 5% (or so) of the Index’s total.  An “ex-Apple” Index might provide an early warning that the overall Index was about to tank.

Or, there could be an earnings Index that excluded the five largest earnings contributors to the Index as well as the five smallest (or most negative) contributors.  Such an Index would also signal an earnings plunge.

Also, this is an election year and I would expect, given today’s choices, that market performance will be heavily influenced by the election’s outcome (to say the least).

Given John’s article, perhaps one strategy would be to remain long Apple and to buy some inverse 500 ETF. 

Or, add some gold and wait for Uncle Ben to restart his printing press.  Gold was $700 on election day ‘08 and around $1600 today.  I would expect that trend to continue, especially if Obama is retained.

Or, simply cash out now and wait for the 50% market plunge John’s article portends and then buy back in.  (Hard to time these moves).

Sebastien Buttet
Aug. 4, 2012, 10:13 a.m.

John, if you were to build similar graphs for the Japanese market and economy in the last 20 years, do you know how they would look like? What I am getting at is, how does the proposed analysis fare in a balance sheet recession environment? With no pressures on input costs (labor and capital) I could see an argument that high profit margins are here to stay for a while.

Thoughts from the Frontline

Recent Articles


Thoughts from the Frontline

Follow John Mauldin as he uncovers the truth behind, and beyond, the financial headlines. This in-depth weekly dispatch helps you understand what's happening in the economy and navigate the markets with confidence.

Read Latest Edition Now

Let the master guide you through this new decade of living dangerously

John Mauldin's Thoughts from the Frontline

Free in your inbox every Saturday

Privacy Policy

Get in Touch

PO Box 192495,
Dallas, Texas 75219

Toll-free: (877) 631-6311
Local: (602) 626-3100

Copyright © 2020 Mauldin Economics, LLC. All rights reserved.
Thoughts from the Frontline

Wait! Don't leave without...

John Mauldin's Thoughts from the Frontline

Experience the legend—join one of the most widely read macroeconomic newsletters in the world. Get this free newsletter in your inbox every Saturday!