This post is a guest con­tri­bu­tion by Vitaliy N. Kat­senel­son*, author of Active Value Invest­ing: Mak­ing Money in Range-Bound Mar­kets and direc­tor of research at Invest­ment Man­age­ment Asso­ciates.

The stock mar­ket has dropped. Cor­po­rate prof­its have col­lapsed. And profit mar­gins have reverted toward the mean. What is next?

Before I dive into the dis­cus­sion, let me explain the chart below, which I named appro­pri­ately, “The pain of mean reversion.”

I looked at reported earn­ings for S&P 500 and com­pared them to the “aver­age case” earn­ings sce­nario. In the “aver­age case” sce­nario I took reported earn­ings of S&P 500 in the early 1990s and grew them at 6% — an aver­age growth rate of GDP over the last cen­tury which hap­pens to be the same as earn­ings growth for stocks dur­ing the same century.

If the econ­omy had no cycli­cal­ity and profit mar­gins remained con­stant, you would see nice, steady growth earn­ings for S&P 500 stocks like the one in the chart.

Of course, profit mar­gins do not stay con­stant — they fluc­tu­ate, thus actual earn­ings swing above and below the steady 6% trend line.

Click here for larger chart.

How far will earn­ings drop?
You’ll never go wrong quot­ing Mark Twain when he said “His­tory doesn’t repeat itself, but it does rhyme.” Our chal­lenge as investors is to look at the past and fig­ure out how his­tory will rhyme with the future.

If you were to look at the recent his­tory of the 2001 reces­sion, earn­ings dropped 54% from their highs to their lows. If S&P 500 reported earn­ings were to drop by the same amount this time around they’d be at about $39. We are already below that level, 2008 esti­mates for S&P 500 were revised down again, now to $28. How­ever, this is where Twain’s rhyming think­ing becomes impor­tant — note that in 2001 earn­ings went only 18% above the “aver­age case” line; in 2007 they were 31% above that line. If we were to fol­low the higher they climb the harder (deeper) they fall logic, this would lead us to believe that earn­ings will drop fur­ther this time, esti­mates for early 2009 earn­ings indi­cate that.

When will we see aver­age earn­ings?
The good news is S&P “aver­age case” earn­ings are about high $70s to low $80s a share (see big red squares in yel­low shaded area) — which would make the mar­ket cheap (with a PE of about 10). But here is the bad news (don’t shoot the mes­sen­ger please) — we just won’t see those “aver­age case” num­bers for a while.

The 2001 reces­sion was dri­ven by the over­ca­pac­ity in the cor­po­rate sec­tor. Cor­po­ra­tions ratio­nal­ized their inven­to­ries and fac­to­ries, higher unem­ploy­ment fol­lowed — we were in a reces­sion. Excesses were worked out, cor­po­ra­tions started to hire, and voila — we were out of the reces­sion. Of course the recov­ery process was also aided by a “friendly” Fed, it took inter­est rates to (at the time) an unprece­dented low lev­els and kept them there until cor­po­ra­tions and con­sumers got seri­ously drunk on cheap money and spent them­selves into seri­ous debt for which we are pay­ing now.

In the 2001 reces­sion it took two and a half years for earn­ings to rise from their bot­tom to their average.

Unfor­tu­nately we’ll not be that lucky this time — we are in a con­sumer reces­sion. Con­sumers are two thirds of the econ­omy and they are delever­ag­ing. As a side note: This delever­ag­ing goes beyond big ticket dis­cre­tionary items like large screen TVs and SUVs. Now it is show­ing up in lower con­sump­tion of sta­ples like iced tea by Snap­ple which com­petes with cheap­est com­mod­ity of all — tap water. Now, more expen­sive branded prod­ucts like dia­pers and tis­sue made by Kim­berly Clark are forced to com­pete with generic store brands. The mean­ing of the word sta­ple is being rede­fined by this economy.

The Fed, being even “friend­lier” than the last time, has low­ered inter­est rates to almost zero, buy­ing long-term bonds etc. But this time around the Fed’s booze will not do the trick — con­sumers are still suf­fer­ing a hang­over from the last Fed’s “help” — they don’t want to bor­row and banks, after incur­ring huge losses, are behav­ing like real banks — only giv­ing loans to peo­ple who’ll pay them back.

In addi­tion to con­sumer delever­ag­ing, gov­ern­ment debt is sky­rock­et­ing with every bailout, thus taxes and inter­est rates are likely to be sig­nif­i­cantly higher once the econ­omy normalizes.

The Earn­ings recov­ery will likely take longer than many expect, there­fore, there is a very high pos­si­bil­ity that the “aver­age case” earn­ings growth going for­ward will be below the his­tor­i­cal aver­age of 6%

Are we about to embark on a sec­u­lar bull mar­ket?
The mar­ket is a dis­count­ing mech­a­nism — stocks will rise in the antic­i­pa­tion of a future earn­ings rebound, before the rebound. Sim­i­lar to the stock mar­ket fore­cast­ing ten out of the last three reces­sions, it will dis­count a few recov­er­ies before the real one takes hold.

What does this mean? We’ll likely have a few “fake” head starts and dis­ap­point­ments before the actual earn­ings recov­ery takes place.

As I argued in my book Active Value Invest­ing: Mak­ing Money in Range-Bound Mar­kets, we are very likely in the midst of a sec­u­lar range-bound (trend­less, volatile but going nowhere) mar­ket that started in early 2000. His­tor­i­cally, range-bound mar­kets started at the end of the sec­u­lar bull mar­ket when P/Es were above aver­age. They ended when P/Es stopped declin­ing (mean revert­ing), after a visit to below aver­age ter­ri­tory (around 10–11 or less). The cur­rent range-bound mar­ket started at much above aver­age val­u­a­tion and will likely rhyme with the past fin­ish at below aver­age val­u­a­tion as well.

Based on the Pain of mean rever­sion chart we are trad­ing some­where between 30 and 10 times earn­ings. How­ever, nei­ther num­ber is very mean­ing­ful. Let me explain:

2008 esti­mates of $28, the “E” in P/E of 30, are dis­torted by mas­sive charge offs.

The “aver­age case,” the “E” ($80) that went into P/E of 10, lies in a far away land that … well, let me put it this way, you and I will get to grow sick of pres­i­den­tial cam­paign adver­tise­ments at least once or maybe even twice before that “E” is in sight.

Even based on 2010 “E” esti­mates ($40) stocks in the S&P 500 are trad­ing at 21 times earnings.

Despite the decline, the mar­ket is still not cheap. Sorry, we are not likely to embark onto the new sec­u­lar bull mar­ket any­time soon. His­tory and data sug­gest that the choppy mar­kets that we have seen since 2000 will likely con­tinue. Own­ing a broad mar­ket index will not pave a road to pros­per­ity. It comes down to not just own­ing stocks but own­ing the right stocks.

P.S. As a side note I believe sig­nif­i­cant earn­ings write-offs will con­tinue well into next year as finan­cial stocks will pass their write-off torch to com­pa­nies in energy, mate­ri­als and indus­trial sec­tors — stuff stocks — that will be writ­ing off the invest­ments they’ve made over the last five years.

By the time, I fin­ished putting these thoughts together, which on and off took about two weeks, 2008, 2009 and 2010 esti­mates were taken down by about 20–25%.

If you missed it, Vitaliy did three 5 minute seg­ment inter­views on Yahoo TechTicker on Tues­day with Aaron Task and Henry Blodget.

1. Only Time Can Cure What Ails Us: Stocks Slump on Bailout, Stim­u­lus News

2. Range-Bound at Best: The Long View on Stocks Isn’t Much Bet­ter, says Vitaliy Kat­senel­son

3. Active Value Invest­ing: The Bull Case for EBAY, Philip Mor­ris and Supervalu

* Vitaliy Kat­senel­son is author of Active Value Invest­ing: Mak­ing Money in Range-Bound Mar­kets and direc­tor of research at Invest­ment Man­age­ment Asso­ciates. He is also an adjunct fac­ulty mem­ber at the Uni­ver­sity of Col­orado at Den­ver, Grad­u­ate School of Busi­ness where he teaches Prac­ti­cal Equity Analy­sis and Port­fo­lio Man­age­ment. Vitaliy, a CFA char­ter holder, received both his degrees — bach­e­lor of sci­ence and mas­ter of sci­ence in finance — from the Uni­ver­sity of Col­orado at Den­ver, where he grad­u­ated cum laude.

Dr. Prieur du Plessis is an investment professional with 26 years' experience in investment research and portfolio management. More than 1,200 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns, including his blog, Investment Postcards from Cape Town. He has also published a book, Financial Basics: Investment. Prieur is Chairman and principal shareholder of South African-based Plexus Asset Management, which he founded in 1995. The group conducts investment management, investment consulting, private equity and real estate activities in South Africa and a number of foreign countries. He also serves as Honorary Consul of Slovenia for South Africa, actively developing economic, cultural and scientific relations between Slovenia and South Africa. Prieur is 54 years old and live with his wife, television producer and presenter Isabel Verwey, and two children in Cape Town, South Africa. His leisure activities include long-distance running, traveling, reading, motor-cycling and scripophily. Read more from the author/contributor here.

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