Stocks: Maybe no bubble, but corporate earnings could fall

Dean Baker is among those who had warned of a potential stock market crash back in 1999. However, he thinks that there is no bubble in stocks at the moment.

If we go...back to the bubble days of 2000, we had a peak S&P of roughly 1500... [T]he S&P would be a bit over 2430 if it were as high relative to potential GDP today as it was at the peak of the 1990s stock bubble.

Another way to put this is that, relative to the potential of the economy, the stock market is about 68 percent of its bubble peak. Would this mean we have a bubble now? By my assessment the answer is no. The PEs at the peak in 2000 were above 30 to 1 (using trend earnings, defined as the average share of profits in GDP). That was more than double the historical average. The current ratio would put the PEs around 20. This is still well above the historical average, but not obviously in bubble territory.

However, John Hussman says that, based on historical episodes of mean reversion, corporate earnings are likely to fall.

At present, the extreme profit/GDP ratio we observe here is consistent with expectations of a 22% annual contraction in profits over the coming 4-year period – which would imply a roughly 63% cumulative contraction in profits from present levels. My impression is that’s probably too aggressive an expectation except as a temporary trough. A more reasonable expectation, in my view, would put corporate profits down about 10% annually over the next few years.

A fall in earnings would put pressure on stock valuations and future stock returns.

The problem is not simply that earnings are likely to retreat deeply over the next few years. Rather, the problem is that investors have embedded the assumption of permanently elevated profit margins into stock prices, leaving the market about 80-100% above levels that would provide investors with historically adequate long-term returns. An equivalent way to say this is that stocks are currently at levels that we estimate will provide roughly zero nominal total returns over the next 7-10 years, with historically adequate long-term returns thereafter.