By Shawn Tully
February 7, 2012

FORTUNE — As fourth quarter earnings come pouring in, Wall Street is assembling the full profit picture for 2011 –– and it’s truly spectacular. According to S&P Capital IQ, the firm that assembles profit data for the benchmark index, earnings will hit $92.17 a share, a 19% increase over the excellent numbers posted in 2010, and well above the all-time record set in 2006. Despite some negative surprises this month—including disappointing news from Alcoa, Cisco and Exxon—momentum and optimism keep building.

According to the bulls, stock prices don’t remotely reflect this historic surge in profits. In fact, they argue that stocks are extremely cheap. Since 2000, earnings-per-share have jumped 84%, while the S&P500 has declined 14%. If Stocks have gone nowhere for 12 years while profits have blossomed, they believe, it’s only logical that prices are bound to catch up.

At first glance, the numbers appear to support that conclusion. Consider the S&P 500’s price-to-earnings ratio, the most commonly used indicator of whether stocks are pricey or cheap. Today, the S&P’s ratio of prices to operating earnings, the bulls’ favorite measure, is 13.6, based on profits over the past 12 months. That’s far below its average of 18 over the past 23 years, when S&P started measuring operating earnings. It’s likely the longer-term average is between 16 and 17. Even compared with that number, stocks look at least 20% underpriced.

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But just because stocks appear cheap based on today’s P/E ratio doesn’t mean they really are inexpensive. The current P/E is a highly unreliable measure of when to buy. The problem is that earnings are extremely erratic, regularly careening from highly inflated to extremely depressed, always reverting from those extremes to long-term averages, as if pulled by a gravitational economic force. When profits are in a bubble, the current P/E is artificially low, wrongly implying equities are a bargain. When they’re depressed, the P/E signals to shun them just when investors should buy. For example, the huge earnings posted in 2006 made equities look attractive, while the paltry profits in 1991 made them look pricey. Investors who bought in 1991 fared far better over the next several years than folks seduced by the ephemeral bargains of 2006.

Today, the evidence is strong that profits can’t stay at these levels—or at a minimum that they can’t grow from here. Three measures point to a bubble, or near bubble. The first is margins, the percentage of sales that fall to the bottom line. The average since 2000 is 6.25%. The figure for 2011 is 8.9%, or 40% above the norm. The second yardstick is return-on-equity. Since 1991, the average return, measured as profits per share to book value per share, is 11%. In 2011, the return-on-equity hit around 15%.

The third alarming indicator is the current level of profits as a share of GDP. In our conversations, Milton Friedman, the legendary economist, used to caution that when profits become an unusually high portion of GDP, they inevitably retreat. In 2011, earnings averaged around 9.8% of national income; over the past 52 years, they’ve only exceeded that number for four quarters. The average share of profits to GDP over that period is around 6%.

The bulls are effectively saying that the “P” is far too low compared with the robust “E,” and has to rise. It’s more likely that E is so inflated that the P will go nowhere or even fall. It’s likely that profits will decline or flatten from these levels simply because they usually peak at this stage in the business cycle. Companies have been benefiting from low interest rates and lean workforces. The potential for cost cutting is mostly exhausted, and companies will need to hire more workers as the economy improves, shrinking margins.

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A close study of the numbers shows that equities are not as undervalued as advertised. The best measure of profits isn’t operating earnings, but plain old reported profits. Operating earnings leave out lots of bad stuff—including restructuring charges and losses from selling businesses—that cost stockholders real money. Since 1936, the average P/E based on reported earnings is 15.7. In 2011, the number is 14.6.

So let’s assume the bulls think that the P/E should rise to the average from a somewhat depressed 14.6. Imagine that the multiple returns to 15.7 in two years, by the end of 2013. A P/E of 15.7 means that stocks should provide a yearly return comparable to their earnings yield of 6.4% plus inflation, which we’ll project at 2%, for a total of around 8.4%. That’s close to the long-term average for equity returns. It’s also what a stock would pay if all of its earnings went to dividends. Right now, the dividend yield is just 2.1%, so earnings need to grow at 6.3% to provide the total return of 8.4%.

We’ll spare you all the calculations, but the rise in the P/E the bulls anticipate would give a big boost to returns. Over five years, the S&P would hand investors around 10% a year. Over ten years, the gains would come to about 9.3%. That’s 7.3 points over a 2% inflation rate, and about a point above the historic average. Those points make a big difference over ten years.

So where would earnings need to be in five years for the bull scenario to materialize? Profits would need to grow from $92.17 a share to $124.50 a share. That’s a 35% increase on top of what looks like a profit bubble. The higher profits become, the harder it is for earnings to keep rising, and the more likely they’ll fall. A 35% profit jump from these levels won’t happen. Not even remotely.

A far more probable outcome is that the 15.7 P/E is restored through some combination of a drop in profits, and a fall in stock prices. For simplicity, let’s say that prices remain flat for the next two years, and earnings drop to bring the P/E from the current 14.6 to 15.7. That would require a 7.5% fall in profits, or more than 10% adjusted for inflation. The adjustment would have precisely the opposite effect of the margin expansion the bulls predict. It would act as a drag on future returns. After two years, earnings would again expand at 6.3% a year from the lower levels, and investors would also collect the 2.1% dividend. Over five years, investors would pocket a total annual return of 5.7%, just 3.7 points over inflation. Over ten years, the picture gets brighter as the influence of the lower P/E fades, with investors getting 7.1% or five points over projected inflation. Not bad, but still well below the over 9% in the optimists’ scenario.

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Actually, the 5 points over inflation view is probably too optimistic. Yale economist Robert Shiller calculates an adjusted P/E called the CAPE or “Cyclically adjusted price earnings ratio.” To get his number, Shiller smoothens out the peaks and valleys in earnings by using a ten-year average of inflation-adjusted profits. The CAPE now stands at 21.7, a high number that bodes ill for investors in equities. “The Shiller CAPE is a much better gauge of the market’s valuation than period earnings,” says Chris Brightman of Research Affiliates, which oversees investment strategies for over $80 billion in funds. “Earnings are quite volatile and profit margins are near a peak. You shouldn’t price long-term assets such as stocks from highly variable current profits.”

Cliff Asness, chief of the $48 billion hedge fund AQR Capital, calculated the average annual returns for ten-year periods starting in 1927, based on the Shiller CAPE that investors buy in at. He found that on CAPEs of between 20 and 22.8––right in today’s range–-investors earn just 2.1 points of return above inflation, on average. That’s one-third of the historic norm. Asness hastens to add that a wide range of outcomes is possible from this starting point––including far higher than normal earnings growth that could boost returns. But investors should take careful note of the odds, and given history, they strongly favor lower-than-average gains.

This analysis doesn’t mean that investors should avoid equities. They’re actually relatively cheap compared with bonds, which, with the 10-year treasury yielding under 2%, are far less attractive than normal.

But stocks are still giving a positive return over inflation, while bonds offer no ‘real’ return at all. So don’t give up on stocks. Just don’t expect anything like the returns the bulls are promising.

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