Over the past two years, on numerous occasions investors have asked us to explain the divergence between the strong recovery in corporate earnings and tepid domestic economic growth. In our view, there are two primary explanations:

1) an increased reliance on overseas sales (particularly emerging markets) relative to prior business cycles; and

2) reasonable leverage in the nonfinancial corporate sector prior to the crisis, which allowed for a symmetrical recovery (unlike the household or public sectors).

It appears to us that both of these factors have run their course, increasing the probability that S&P 500 revenue growth in 2012 will revert to its long-term relationship with nominal GDP growth. Based on our read of trends in bottom-up consensus estimates for S&P 500 earnings and leading indicators of earnings growth - such as analysts earnings estimate revision momentum and ratios of negative to positive pre-announcements 4Q11- we expect results in late January/early February to show that S&P 500 earnings growth will slow to mid-single digits.

As recently as August, following strong 2Q11 earnings reports, bottom-up consensus earnings growth for 2012 was roughly 15%, similar to the growth rate in 2011. This changed quickly following the late July benchmark GDP revisions, debt ceiling debate, U.S. sovereign ratings downgrade, stock market decline and associated drops in consumer and business confidence. The 2012 consensus growth estimate fell from $113 to $108 between 2Q11 earnings reporting season (late July/early August) and 3Q11 reports in late October/early November. By early October, stock prices had overshot the slowing earnings growth rate. When the S&P hit its 2011 low in early October, our read of the relationship between earnings growth and multiples implied a market expectation of negative earnings growth in 2012.

The combination of better-than-expected 3Q11 earnings and a series of strong economic reports triggered a rally in stock prices to a level consistent with our 6% 2012 earnings forecast and also served to stabilize the forward earnings estimate. Currently, the bottom-up consensus estimate still calls for double-digit growth and with Europe likely heading into recession and growth from the countries that added considerably to global growth in the economic recovery - China, Brazil, and India - also slowing, expected earnings growth is likely again headed lower, albeit at a much slower rate than during the August-October period. In addition, according to Thomson Reuters, the ratio of negative to positive pre-announcements at 3.6 is well above the long-term average (since 1995) of 2.3 and at the highest level since 2Q01 during the technology investment bust recession.


source: BarCap