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Stock market's next hurdle: Peak Earnings

March 22, 2012: 2:40 PM ET

Now that the economy finally seems to be firmly in recovery mode, it may be time for investors to brace themselves for a slowdown.

FORTUNE -- There is always a disconnect between Wall Street and Main Street. But that has been more true in this recovery. Corporate profits have zoomed higher, while the economy has only slowly added jobs. Usually that disconnect narrows when the economy improves.┬áBut because it has been so severe this time around, the relationship between corporate profits and GDP could flip completely – with jobs coming back strong while profits shrink. While that's good for the unemployed, it might mean trouble for the stock market.

Indeed, a number of market watchers believe the rapid corporate earnings growth we have had coming out of the recession might already be coming to an end. The issue: A slow growth economy mixed with corporate budgets that have been stretched as thin as possible might lead to a disappointing profit performance for U.S. companies in 2012. "Earnings growth has been well ahead of trend," says top market strategist Rob Arnott. "Historically, it is more likely that profits will fade from here rather than surge onto new heights."

Arnott, who also is the CEO of money management firm Research Affiliates, is one of the most outspoken proponents these days of the so-called peak earning theory, meaning profits are as good as they are going to get, at least in this business cycle. Arnott has looked at corporate profits for publicly traded companies for the past 140 years. What he has found is that corporate profits, adjusted for inflation, tend to peak when they are 60% higher than the average earnings of the past ten years. And that's where we are now, or at least close to it. Last year, the average quarterly earnings of the companies in the S&P 500 (SPX) was $21.75 per-share. That was 67% higher than the average quarterly earnings of the previous decade. I didn't adjust the earnings for inflation, but inflation has been pretty low over that past decade. So even after inflation I would say we are at least 50% above the 10-year average. That means based on history profit growth for the S&P 500 companies this year should be flat at best, and more likely down.

The problem is that's very different from what Wall Street analysts in general are expecting. On average, analysts predict profits for companies in the S&P 500 will rise nearly 15% in 2012. "I have concerns about the second half of the year," says Howard Silverblatt, senior index analyst at Standard & Poor's. "Unless we get to Carter level inflation, I don't think we are going to see the earnings growth that some people are predicting."

The good news is, at least right now, a profit disappointment might not be that bad. Stocks trade at a p/e multiple based on next year's projected earnings of 14. If you believe analysts' earnings estimates, that's relatively cheap (at least for the last few decades). And it's why some people have argued that the market is set to go higher. But if this year's earnings instead end up being the same as last year, or drop, the p/e of the S&P 500 might be more like 16 or higher - much closer to where p/es have averaged for the past 20 years. That doesn't mean the market is set to drop, but it may not be cheap, either.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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