Recap 12-12-12: ERP Followup


Yesterday’s post generated a fair bit of interest, so I wanted to make a few more points.

First, yesterday’s analysis certainly does not preclude the possibility that earnings growth could substantially exceed nominal GDP growth over the next 12 months. However, for that to happen, either S&P revenue growth needs to substantially exceed nominal GDP growth, or after tax profit margins need to increase. The former is not particularly likely, so let’s look at the likelihood of margin expansion. Currently, S&P profit margin sits at ~13.4%. If nominal GDP growth 5%, for profit growth to hit 10%, margins will need to expand to 14.1%. That would take margins to just below the Jan 2007 high of 14.5%. So while that is certainly possible, the probability and sustainability of this type of move is questionable. Also, it is worth noting that this type of increase in earnings growth is not sustainable – profit margins can not continue expanding forever. As a result, since this improvement in earnings growth is not recurring, it may not have a significant impact on long term valuation metrics like the ERP.

Second, I thought it would be interesting to revisit how the ERP has evolved historically. So below is a chart of the S&P ERP going back to the early 60’s. Note the two instances where ERP has decreased – the late 60’s and the early 80’s. Note that in both instances, it was higher bond yields which drove the move. I think the best scenario that we can hope for this time is a repeat of the late 60’s scenario – whereby a gradual increase in yields was absorbed without much of an equity valuation rerating. A sharp up move in treasury yields will undoubtedly cause massive havoc – most likely even worse than the early 80’s period given how much more levered the economy is now.


  • FOMC:
  1. the Committee decided to keep the target range for the federal funds rate at – to ¼ percent… at least as long as the unemployment rate remains above 6-1/2 percent, inflation between and two years ahead is projected to be no more than …[2.5%], and longer term inflation expectations continue to be well anchored.
  2. Vote was 11-1

Fed 2013 Forecasts:

  1. Growth range slightly wider, 2.3-3.0%
  2. Unemployment: 7.55%, down 0.2%. 2014 est is 6.8-7.3%, 2013 is 6.0-6.6%
  3. Core PCE: 1.75%, down 0.1%.

The Journal reported that the Fed told large banks not to think about large M&A deals for the time being.

UK ILO Unemployment was stable at 7.8% in Oct as exp.

North Korea launched a rocket overnight, in what it said was an attempt to place a satellite into orbit.

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