After exceeding expectations for more than two years, earnings this year seem poised, at last, to reflect the plodding nature of the economic recovery. In 2010 and 2011, even as the real economy managed only a paltry 2.4% average annual rate of expansion, the earnings of S&P 500 companies soared, rising more than 47% in 2010 and almost 20% in 2011. Such a pattern could not persist, and this year the slow fundamentals will almost surely assert themselves. Even so, it would be a mistake to read matters too pessimistically. There certainly is nothing ominous in the pattern. It is well-established historically that earnings should come into line with slower-growing revenues in this, the third year of economic recovery. Besides, this year's probable 10% earnings growth, though only about half the pace in 2011, is sufficient to sustain the stock market rally.

The unfolding pattern of surge and moderation is hardly surprising or new. It has, in fact, become a cyclical commonplace, a reflection of the increasingly huge operating leverage of American business. Every year, businesses rely more and more on machinery, facilities, systems and other forms of technology, often in place of labor. Because the trend builds a larger proportion of fixed costs into the production model, even slight variations in revenue have an exaggerated impact on the bottom line. In the more distant past, when variable labor costs were a bigger part of the overall production equation, layoffs could reduce a significant part of overall costs and so relieve some of the strain on the bottom line during recessions. Then when rehiring raised labor costs in recovery, the profit recovery was more muted. But operating leverage has introduced a more volatile pattern.

The dramatic effect was clear during the last recession and the recovery so far. In 2008-2009, when the real economy dropped 5.1% peak to trough over 18 months, revenue followed. But because businesses had little ability to cut costs, the full brunt of the downturn fell on earnings, which for the S&P 500 plunged from almost $22 a share in the second quarter of 2007 to a loss of more than $25 a share at the end of 2008. But however much strain the operating leverage imposed during the recession, it has worked in businesses' favor in the recovery. As this huge array of productive capital has come back on line, the fixed costs allowed virtually all the additional revenue to fall to the bottom line. And because profits are a small difference between revenue and costs, the small percentage gains in revenue create huge percentage changes in profits. But now, in this third year of expansion, when most of this productive capital has at last become more fully utilized, the effect of operating leverage should dissipate, forcing earnings to follow slower revenue growth more faithfully.