SERIOUS MONEY:STOCK MARKETS are closed for Good Friday commemorations today, but the Easter Bunny arrived early on Wall Street, as the breathtaking advance in the major indices that began last spring continued during the first three months of the year with only a minor interruption in late January.

Stock prices have jumped more than 70 per cent over the past 12 months, pushing valuation multiples back into nosebleed territory. Earnings expectations embodied in current prices appear to be completely divorced from the realities of the post-crisis environment.

Analysts’ rosy projections currently call for an almost double-digit per cent increase in revenues both this year and next, and a cumulative 60 per cent increase in earnings- per-share, as both profits and margins soar to record levels.

It appears that the blue-sky thinking that characterised the “old normal” is alive and well in the post-crisis world.

The current upbeat consensus is inconsistent, however, with the roughly 5 per cent growth in nominal GDP that economists have pencilled in both for 2010 and 2011. The stage has been set for disappointment.

Corporate revenues are a function of nominal GDP and a simple linear regression, as expected, confirms that the year-on-year percentage change in quarterly GDP measured in nominal terms, explains almost 80 per cent of the variation in quarterly sales year on year.

Revenues are significantly more volatile than the broader economy and GDP growth rates of 3.5 per cent or less are accompanied by declining sales, while year-on-year revenue increases of 10 per cent or more are associated with economic growth rates above 6.5 per cent.

Consensus Wall Street expectations look for a 9 to 10 per cent increase in revenues during the current year, which is consistent with nominal economic growth of more than 6 per cent.

However, the consensus among economists sees little more than a 3 per cent advance in real GDP in 2010 and no single forecast looks for anything close to the almost 3 per cent inflation rate that would be required to produce the nominal growth consistent with current revenue expectations.

The top line could fall short of current expectations by a few percentage points.

The diehard bulls will argue that the relatively optimistic sales forecasts are attainable given that comparisons are easy following the 12 per cent drop in sales-per- share last year.

However, it is worth noting that the aggressive cost-containment measures implemented over the past two years resulted not only in a suspension of growth initiatives, but also outright depletion of the asset base.

Corporate America reduced the amount spent on research and development by more than $15 billion or roughly $1.70 a share last year and cut capital expenditures to an amount that was less than the annual depreciation charge for the first time in the post-second World War era.

It is hardly a stretch to suggest that such drastic measures will have a negative impact on the corporate sector’s future revenue-generating capability.

The fanciful revenue projections are accompanied by earnings forecasts that envisage record corporate profits and margins by 2011. It is implicitly assumed that the economic model, that failed spectacularly as the Great Recession took hold, will somehow be resurrected.

The blue-sky thinking implies that corporate profits will return to the historically elevated share of GDP seen over the past decade, while the labour compensation share languishes at a 50-year low.

This flawed model worked so long as rising asset prices created a sense of increasing wealth that allowed households to borrow and spend in the face of stagnating real incomes, but excessive growth in household debt is unlikely to be a feature of the post-crisis age.

It is far more likely that margins disappoint as pricing power remains absent in the face of a severely oversupplied labour market and significant surplus capacity.

It is instructive to note that the corporate sector typically seeks to maintain margins as excess capacity builds, through expense control, and is initially reluctant to reduce prices. However, further expense reduction often becomes impractical without negatively affecting the underlying operations and businesses inevitably resort to price discounting to stimulate demand and utilise spare capacity.

Thus, company selling prices react to excess capacity with a lag and remain under pressure during the early stages of an economic expansion. Investors often overlook this fact and consequently, it is likely that current margin expectations are too high.

The current price multiple on 12-month forward operating earnings that embody fanciful revenue and margin projections is more than 15 times as against a long-term average of 12 times.

Current valuations leave little room to manoeuvre and, although momentum is clearly with the bulls for now, investors would do well to remember that fundamentals do matter.