Beware of Head-Fake Rallies
February 24, 2009
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The stock market has dropped. Corporate profits have collapsed. And profit margins have reverted toward the mean. What is next?
Before I dive into the discussion, let me explain the chart below, which I named appropriately, "The pain of mean reversion."
I looked at reported earnings for S&P 500 and compared them to the "average case" earnings scenario. In the "average case" scenario I took reported earnings of S&P 500 in the early 1990s and grew them at 6% -- an average growth rate of GDP over the last century which happens to be the same as earnings growth for stocks during the same century.
If the economy had no cyclicality and profit margins remained constant, you would see nice, steady growth earnings for S&P 500 stocks like the one in the chart. (See chart above or click here to view larger chart)
Of course, profit margins do not stay constant -- they fluctuate, thus actual earnings swing above and below the steady 6% trend line.
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