As was mentioned in a previous article, the 12-month earnings which includes Q1 2017 are below the Q3 2014 peak. This 6.3% decline cannot be emphasized enough given misleading headlines about earnings growth driving stocks higher. If earnings falling didn’t push stocks lower, you can’t make the case that earnings growth is pushing them higher. While earnings are down 6.3%, margins are much closer to their peak. Margins peaked at 10.10% in Q3 2014; they are now at 9.95%. That’s only about a 1.5% decline which signals revenue growth hasn’t rebounded as quickly as earnings have.

One aspect of the debate between the bulls and the bears is whether margins can stay at their peak. The bears have the upper hand in this debate because margins mean reverting is only one part of the bearish thesis, while bulls rely on record margins to support their optimism. The point I’m making is that even with peak margins, stocks are expensive. If revenues and earnings were to grow indefinitely at a 7% clip, stocks would still be expensive. The chart below shows the forward earnings estimates as compared to a fixed 7% growth rate. Usually at the end of cycles, the forward earnings growth gets ahead of that 7% growth rate, but even with record margins, earnings have not yet exceeded that fixed line in this cycle.

Bulls believe that earnings won’t revert to their mean because of technology stocks. This reminds me of the technology bubble in the 1990s where believers argued that stocks didn’t need profits to be good investments. They were correct in the short run as firms without profits had great performance for a few years. The current crop of late cycle bulls have also been correct, but their proposition is wrong. Firstly, firms will always succumb to competition which will shrink margins. Firms with economies of scale which have natural monopolies like Amazon, Google, and Microsoft will have longer periods of plateauing margins, but in a free market upstarts usually take market share through innovation. One example of this is how Facebook changed search by introducing people.