In case you haven’t noticed, there’s a bull market in stocks. Our particular interest in this essay is U.S. stocks, for which the S&P 500 is the oft-quoted benchmark. By that measure, the recent past has been good if not spectacular.
Through yesterday, the S&P 500’s total return for the past year is a nifty 12%, comfortably above the long-term average of around 10%. For the past three years, the annualized total return isn’t quite as strong, but tidy nonetheless at 9.7% a year, according to Morningtar.com.
The market’s rise has been warranted based on the surge in corporate profitability, which has of course translated into earnings growth. In fact, the earnings growth has been extraordinary. As outlined this morning by Bob Doll, chief investment officer for Blackrock, S&P 500 earnings have advanced at a double-digit pace for each year starting in 2002. Once the final numbers are in for 2006, Doll believes that S&P operating earnings will climb by 18%, he explained today at a press conference in New York, where yours truly was in attendance.

“Earnings have gone up faster than the stock market since 2002,” Doll observed. As a result, the price-earnings ratio on equities has been flat to declining in recent years.
All of which seems to suggest that U.S. stocks are reasonably valued, if not undervalued. Doll, for one, is optimistic about equity returns for 2007, in part because the valuation levels on stocks look reasonably alluring, at least by Doll’s reckoning. In an accompanying press release tied to this morning’s festivities, Doll said that “price-to-earnings ratios for the S&P 500 Index are now at their lowest levels in 12 years. In our opinion, the second half of the bull market will most likely be fueled by expanding valuations, with price/earnings ratios expanding for the first time in six years.”
Perhaps, although we’re inclined to raise a question or two about what comes next for stocks. Let’s start with the outlook for earnings in 2007. Using Mr. Doll’s numbers, this year will witness a sharp slowdown in earnings growth for the S&P 500 relative to the recent past. Blackrock’s estimate for this year calls for a 5% rise in S&P earnings, or less than a third of 2006’s estimated 18% gain. The long-term average rise in earnings is 7%, according to Doll’s handout.
The downshift in earnings momentum coincides with slower economic growth. U.S. GDP will rise by 2.4% this year, down from 3.3% for 2006, Blackrock forecasts.
The question that weighs on us: How will Mr. Market react to the earnings downshift? Yes, we know that continued growth at this stage of the economic cycle is impressive. But if the stock market rose by only slightly more than its long-term average return with a backdrop of extraordinary earnings growth, how will the crowd react when earnings roll in at a below-average pace?
One might wonder if the stock market is prepared for the earnings future that awaits. As Doll noted, bottom-up analysts collectively figure that S&P earnings will advance by 9-10% this year. That’s almost twice as much as top-down analysts and Blackrock predict. The gap, Doll told us, isn’t unusual: bottom-up analysts are typically more optimistic than top-down strategists.
In any case, the general outlook for slower earnings growth we speak of is no secret. Most investment strategists have been advising that 2007 will bring a substantially slower rate of growth in corporate earnings. Logic suggests no less. As any student of economic history knows, corporate earnings overall can’t growth faster than the economy for very long. The 2002-2006 experience has been the exception to the rule. Something approaching normal awaits in 2007 and beyond for earnings growth. If so, what does that imply for equity returns? We don’t have an answer today, but we have our suspicions.