Earnings are the fundamental source of the value of common stock. Although short-term market movements are unpredictable, in the long-run the market capitalization of companies cannot grow faster than their earnings.  On an economy wide basis, furthermore, earnings cannot grow faster than GDP unless the fraction of earnings to GDP continues to rise, which makes no sense economically or politically.

The foregoing implies that to understand the recent behavior of the S&P 500 (.INX), it is useful to take a look at the behavior of the earnings to GDP ratio.  Based on data from the Federal Reserve, the chart below plots the ratio of total corporate profits to GDP.

figure 2a corporate profits as a percent of GDP 1947 2012

As the basic theory predicts, the ratio is trendless. Because earnings are more volatile, the ratio rises during good times and falls during bad times, but it always tends to revert to its mean value.  The most notable feature of the chart is the recent behavior of the ratio.  It reached its maximum in 2007, dove close to all-time lows in 2009, and then recovered to near record levels by the end of 2012, mimicking closely the behavior of the market.

The chart appears to serve as a warning. The ratio has risen to near record levels. If it reverts as usual will stock prices fall?  The answer is they should not because the mean reverting behavior of the ratio is well documented and, therefore, should be reflected in market prices. But there is a caveat with the foregoing should. Research by John Campbell and Robert Shiller indicates that the market fails to fully account for the tendency of the ratio to revert.  If that is the case again, the chart does suggest that the rapid run-up in stock prices is likely coming to an end.

 By Brad Cornell, Professor of Finance at Caltech