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.

Still, even as 2012 fails to enjoy the remarkable earnings surges of 2010 and 2011, the outlook for this year is not as depressing as some media reports imply. Earnings can still outpace the 5% to 6% expected advance in domestic revenue because there is still some operating leverage left in the system, and because S&P companies gather more than half their revenue abroad. Europe's recession, of course, will weigh against foreign revenue growth, but the emerging economies should more than offset Europe's depressing influence. Though these economies, too, have slowed, and that fact has attracted a lot of attention, they still outpace the United States and other developed economies by far. China, after slowing, still registers real growth of over 8% and India over 6%. In nominal terms, which, of course, is the way revenues are measured, those economies should still contribute double-digit growth for their part of the 2012 S&P revenue equation. When that's added to likely overall revenue gains of 7% to 8%, the remains of operating leverage should bring S&P earnings growth up to about the 10% figure in 2012.

That growth, though half last year's pace, should nonetheless allow equity markets to hold the gains they have already made and likely rise further. Even after market gains of the last six months, valuation measures are far from stretched. Price-earnings multiples, after all, depending on which of the seemingly endless calculations one chooses, show a market that at worst is near its historical valuation benchmark, allowing it room to keep up with earnings at least. Since, in most other respects, valuations are still more attractive, equity price advances should exceed the earnings growth. And relative to Treasury bonds, stocks offer valuations not seen since the early 1950s or even the Great Depression. Next to corporate bond yields, equity valuations look less dramatic but still suggest considerable upside potential. It is noteworthy that, even today, dividend yields on many stocks atypically exceed the yields on the company's own bonds. 

Since earnings, though slowing, are still showing substantive growth, the most conservative interpretation of valuations would suggest that equities should hold this year's gains so far. Anything other than the most conservative interpretation suggests greater gains.