Can profits keep rising? Uncle Miltie said no

In 1999, Milton Friedman outlined why that stock boom couldn't beat iron-clad limits on profit growth. We're facing the same wall today, says Fortune's Shawn Tully.

By Shawn Tully, Fortune editor-at-large

NEW YORK (Fortune) -- "Would you accept the charges from Milton?" the operator would ask. I'd eagerly agree, knowing that the caller was my hero, the great economist Milton Friedman, who died last November. He always called collect. He was my only source who ever called collect. And the humor didn't escape him. One time, after the operator's Brooklynese introduction, he intoned in his trademark monotone, "I was most amused at the operator calling me Milton."

Friedman shared his insights with me on topics as diverse as the potentially damaging effects of the Euro, how subsidies distort the medical market and whether government spending is destined to overwhelm growth in GNP.

Milton Friedman, July 31, 1912 - November 16, 2006

But one of my most memorable conversations involved his views on the stock market, and specifically, how fast corporate earnings can grow. Now that we've seen an earnings explosion, and the bulls are predicting that profits will keep roaring, the Great Man's sobering views are well worth reviewing. Thinking about Friedman's take on the stock market today is like getting a collect call from the economists' Arcadia.

It was in 1999, when profits were soaring, and stocks posting record PE's. I asked Friedman if he thought the current market reflected the true, future earning power of stocks, since according to the Chicago School, markets are efficient - meaning that the best available information is always reflected in stock prices.

Friedman, of course, was a Chicago man, and a god to the efficient market crowd. But to my surprise, Friedman didn't agree with the theory espoused by his admirers and protégés. "In the long term," he told me, "stock prices do reflect profit growth. But in the short term, the stock market is far from efficient. Stock prices are full of noise."

He said that while he wasn't sure, he thought that the stock market was probably overpriced (according to the Chicago crowd, it's always, or almost always, priced rationally and correctly). Friedman's reason was basic: the iron-clad limits on profit growth.

"Earnings can't grow faster than GDP for a sustained period," he said. When we talked, Friedman felt stock prices were so high that profits would have to grow far faster than GDP, from already lofty levels, to sustain the huge valuations. He thought that such growth - which meant that earnings would need to hit unheard of levels as a portion of GDP - was highly unlikely. As we all know from the subsequent crash, Friedman was right - as usual.

Danger signals

Today, investors are in a quandary all too reminiscent of the prelude to the bubble. So let's see if profits can possibly grow fast enough in the future to justify today's stock prices, just the problem I put to Friedman seven years ago.

Since early 2002, earnings have been posting enormous, even historic gains. In the past three years, S&P earnings per share have jumped 65 percent, or almost 18 percent a year. The analysts polled by Thomson Financial predict a gain of 7.2 percent for 2007, still a big number, especially considering that we're already in record territory.

The fact is that profits are highly volatile. Right now, they're in an historic spike. But it would be folly to predict that the spike is sustainable, let alone that earnings will push still higher. They're hitting the wall that Friedman talked about, growth in GDP.

Let's put the earnings explosion in perspective. In 2000, S&P earnings hit a cyclical peak. They then dropped by 50 percent the following year, as companies wrote off tens of billions from closing plants, firing workers and writing off goodwill from overpriced acquisitions. It took until the end of 2004 for earnings to simply return to their previous record levels. In other words, the much ballyhooed 2001 to 2004 earnings "boom" was all catch-up.

The real story began in 2005, when the S&P posted double-digit gains quarter after quarter. By the end of 2006, earnings stood at almost 60 percent above their apogee in 2000. That means they jumped an average of over 8 percent a year over those six years, far above GDP growth of 5.1 percent (including inflation).

The reason for the huge gains, says Gus Faucher of Moody's, is that productivity has increased dramatically, but labor costs have remained relatively flat, so that the gains have flowed to shareholders rather than workers.

Today's profit levels, and a number of other signals, are flashing danger signals for investors - for five reasons. First, we're not in a new world where productivity gains will keep going straight to profits. "Far more of the future gains will go to workers," says Faucher.

Second, earnings are now at unsustainable levels of GDP, precisely the scenario that worried Friedman in 1999. Profits stand at 12 percent of national income, the highest level since the 1960s, and 33 percent above the historic average of 9 percent.