Bull market for stocks.
The U.S. economy is recovering, the S&P 500 has been hitting record highs this month and investors are putting more money into stocks.
There's one problem with this bullish picture, though: Corporate profits aren't keeping up, offering a source of anxiety for anyone wondering if the stock market is sputtering after a four-and-a-half year bull market.
According to Bloomberg News, the S&P 500 is outpacing profits at the fastest pace since 1999 – an uncomfortable comparison because it alludes to the most notorious days of the dot-com bubble.
When the bubble burst, the S&P 500 fell 49 per cent.
Of course, stocks don't look nearly as frothy today as they did back then. For one thing, stocks trade at 16-time earnings now, versus 30-times in 1999.
Nonetheless, the disconnect between earnings and share price gains offers a challenging hurdle for market performance in the months ahead.
The S&P 500 has surged nearly 150 per cent since 2009. It is up 17 per cent so far this year alone, a remarkable gain that stands as the best year-to-date performance in 16 years.
Yet, earnings are following a far different flight path after big gains earlier in the recovery. According to Bloomberg, combined earnings from companies in the S&P 500 rose 37 per cent in 2010, after companies emerged from the financial crisis with the help of unprecedented economic stimulus plans from the Federal Reserve. Earnings rose another 19 per cent in 2011.
However, the pace slowed to a mere 2.3 per cent in 2012, amid sluggish U.S. economic growth and stubbornly high unemployment. And in the first and second quarters of this year, earnings have risen just 3.6 per cent year-over-year and 3.7 per cent, respectively.
In other words, even as companies proved themselves incapable of driving their earnings much higher, investors have been willing to pay more for those earnings.
This divergence does not look sustainable, especially when you consider some of the other less-than-encouraging statistics hanging over market right now, such as age.
"Secular equity bulls must concede that the current S&P 500 bull market is 'mature' both in terms of duration (53 months versus an average of 56) and return (150 per cent versus an average of 163 per cent)," said Michael Hartnett, chief investment strategist at Bank of America, in a note.
"History does not suggest significant upside to U.S. stock indices from current levels, especially given the absence of a meaningful correction in the equity market in past 18 months."
Wall Street strategists have been boosting their year-end targets for the S&P 500 as the index has sailed past their previous forecasts. Overall, though, the targets look cautious, with an average of 1677 – a mere 19 points or so higher than the current level of 1657.91.
For sure, surprises can be pleasant. Thomas Lee, JPMorgan's strategist, is one of the most bullish observers on Wall Street. He believes corporate spending should pick up. If it does, there would be knock-on benefits to economic growth.
As well, the euro zone economy appears to be in the early stages of a modest recovery and the United States has been generating strong jobs growth in recent months – in fact, so strong that the Fed is now contemplating an end to its economic stimulus.
Investors, long shy of U.S. stocks, are now favouring the market with the strongest inflows into U.S.-equity exchange-traded funds since 2008. If the trend persists, valuation multiples could rise even higher.
But it's becoming increasingly difficult to ignore the fact that investor enthusiasm is getting way ahead of corporate performance.
Either earnings have to catch up or enthusiasm has to come down.
David Berman