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The dim future for stock prices

January 13, 2014: 5:00 AM ET

Already at record levels, corporate profits aren't likely to boost the S&P 500.

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FORTUNE -- As the New Year begins, America's equity strategists, analysts, and pundits are making their forecasts for 2014 and beyond. And as usual, Wall Street is speaking with one voice: The talk you hear on the business networks and in the banks' "cheat sheets," "chartbooks," and "equity year ahead" reports is so overwhelmingly, uniformly positive that it's positively boring.

It shouldn't be, because the opposite case is far more compelling and alarming. It has both math and history on its side.

This time, the conventional view is that a surge in profits will drive stock prices far higher in 2014, and for many years thereafter. That's something of a departure from the experience of the recent past, but it's absolutely essential to bolstering the argument for equities. In recent years, the story hasn't been robust earnings at all, but steeply rising prices. Since the end of 2011, profits for the S&P 500 (SPX) have risen just 11.2%, or around 5.5% a year, an extremely mediocre performance.

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By contrast, the index has jumped 45% in the same period, outstripping profit gains by 34 points. The explosion in prices relative to earnings has driven the S&P price-to-earnings ratio from 14.5 to 18.9. The average P/E since 1928 stands at 16, which means that investors' enthusiasm for stocks has transformed a bargain into a relative extravagance signaling danger ahead.

Even the bravest bulls wouldn't argue prices will continue to far outpace the earnings that must eventually justify those prices. Hence the rationale that we're on the cusp of a big upswing in corporate profits.

Let's examine the predictions that have been welcoming the New Year. Overall, America's equity analysts project that EPS for the S&P will rise 9.6% in 2014. In most cases, the individual banks forecast that earnings will grow at close to double digits, and P/Es will shrink a bit, so that investors will get both solid returns, and stocks will reestablish highly attractive levels of valuation through the elixir of fast-rising profits. It's a Wall Street classic.

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Goldman Sachs (GS), for example, sees the S&P gaining slightly more than 7% annually over the next three years, and profits growing even faster on an annualized basis, at 8%. Bank of America (BAC) forecasts 10.2% earnings growth for 2014, versus an 8.9% increase in stock prices. So both scenarios draw a future of both big returns and cheapening valuations, all courtesy of strong earnings. An exception is J.P. Morgan (JPM). The bank has a 2014 target of 2075 for the S&P, a gain of 13%, with earnings rising only 9%. In that scenario, the current P/E would get even richer in a continuation of the mania of 2012 and 2013.

What are the odds that profits will swell at a double-digit rate? It's important to note that profits already stand at record levels: Operating profits as a percentage of sales are now 9.7%, the highest level in the 20 years S&P has been tracking that metric. That exceeds the 9% in the flush days of 2006 and 2007, and it's an extraordinary 2.6 points above the two-decade average of 7.1%. Keep in mind that a high PE (at over 19) on top of all-time record profits means that stocks are really far more expensive than they appear.

For the bull case to win, earnings must rapidly rise from these already record levels. "For that to happen requires one of these, This-time-it's-different, new-normal arguments," says Jason Hsu, co-founder of Research Affiliates, a firm that oversees strategies for $156 billion in investment funds. Hsu notes that U.S. companies' heroic profit performance is chiefly the result of cost-cutting following the financial crisis, not revenue growth. "Companies are down to their core businesses and most productive people, all the rest is gone," he says. "It's not a growth story. Companies have not been investing in new products and technologies that would create strong growth in the future." In fact, over the past two years, S&P revenues have barely grown at all, remaining flat at around $10 trillion on an annual basis.

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Nor have earnings been surging of late. They've remained flat for the last four quarters, suggesting that it's extremely difficult to build big gains on top of already record results.

In the face of daunting numbers, the pundits argue that the economic recovery now gaining momentum will allow profits to bust through what appears to be a ceiling. Hsu agrees that revenues will increase with renewed growth in GDP. But that doesn't mean profits will grow at faster than normal rates. It's highly possible that margins will fall from their historic highs, offsetting at least part of the increase in sales. Companies will need to hire more workers as they expand, driving up costs. Indeed, if they are to grow, companies will need to plough tens of billions in extra cash into capital investments, something that isn't happening yet. Those investments will raise costs of interest and depreciation.

At best, margins will remain flat. "The era of cost-cutting is over," says Robert Corwin of research firm EVA Dimensions. Hence, the bulls -- without saying so -- are resting their entire argument on what must be huge increases in revenues. How big is huge? Let's take J.P. Morgan's prediction of 9% EPS growth. Usually, EPS grows about one point slower than overall earnings since companies are constantly issuing more shares. So if EPS waxes at 9%, profits in the overall economy need to grow at 10%. So at constant margins, what revenue growth is needed to hit that target?

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Profit expansion of 10% equates to "real growth" of 8% or so, since inflation is running around 2%. That's four to five points higher than the 3% to 4% GDP-increase figures that would be highly welcome for 2014. It won't happen.

"The problem with the argument that profits can grow from already high levels is that they'd eventually absorb most of the economy," says Hsu. "More likely, they go back to the average, not soar above it forever." His conclusion is that at already high prices, only two possibilities exist. The first is that investors now think the world is a safe place, and are happy with low returns. If that's true, stocks should deliver around 4% real returns, the 2% dividend yield, and 2% real EPS growth that's the historic average.

For Hsu, that's the less likely outcome. "The highly volatile component is what happens to valuations," he says. "If PEs go back to normal, revert to the mean, then investors will have negative returns over the next five years. That doesn't have to happen. They could get lucky. But history is the guide, and on average from these levels you can expect poor returns." But Hsu puts the chances that investors who buy now will suffer negative real returns by 2018 at 60% and 65%.

An important proviso is that high valuations tell you little or nothing about what will happen over the next year. That's a good reason to ignore the pundits who love short-term predictions, such as "We'll go through a tough patch mid-year, and then the bulls will be back in charge late in the year." But buying in at high prices almost always yields disappointing returns over five or 10 years. Wall Street has never been more challenged to create arguments that it's a good time to buy stocks. It's performing an amazing feat of salesmanship. Don't believe it, investors. Let the lessons of history, and real market math, be your guide.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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