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We are all aware of the pitfalls of getting caught in a falling market.

But there are also risks associated with underestimating the recovery in earnings and getting in too late in a runaway sharemarket.

This is precisely why the question occupying the minds of professional investment banking strategists and economists is whether the sharemarket, which has risen strongly since April, has gotten ahead of itself or whether the earnings outlook will support the rising share prices.

History has demonstrated very clearly that sharemarket analysts usually underestimate earnings upswings and downswings, given they are typically conservative and have a pack mentality.

In this year's profit season, the earnings that we have seen are running ahead of analysts' expectations – which is not all that surprising, as until a few months ago corporates were painting a financial Armageddon. Market consensus for the 2010 year is also for negative earnings growth but there are economists and strategists now questioning whether there is more upside to earnings than is being forecast.

Certainly those with brighter predictions are focusing their optimism on cyclical stocks – whose revenue was decimated in 2009 as the global slowdown hit company sales.

The key to their analysis is costs – or what in the trade is called operational leverage. In times of economic slowdowns when companies' revenues are put under severe pressure, the management's response has been to take a axe to the cost line.

This is a feature in all slowdowns and is particularly relevant to the present situation, which is arguably as bad as it has been since the 1970s. Already in this reporting season there have been many examples of revenue being in accord with expectations, but earnings before interest and tax depreciation and amortisation being better than anticipated.

This appears to be due to managements responding quickly to the fall in demand for their products and starting to cut into their cost bases.

Companies such as BHP Billiton, Boral, Qantas, Leighton and Stockland – all cyclical – have surprised the market by harnessing some of this operational leverage. When predicting next year's corporate earnings, there is an reasonable argument that this cost-cutting will feature even more strongly.

Plenty of management commentary on the outlook suggests this. Thus there are a couple of reasons to be more bullish on 2010 earnings growth. The first is that the current year's earnings will be coming off the low 2009 earnings base.

The second is that companies will be in the full cost-cutting swing and even if the recovery in the economy is only tepid, the hardline on costs will give companies more leverage to any improvement in revenue. It's reasonable for investors to question whether the broader economic recovery will be V-shaped or U-shaped.

The fashionable notion right now among some economists is to suggest that the worldwide downturn virtually bypassed Australia and that the Government wildly overresponded with its stimulus (the equivalent of 4.6 per cent of GDP over 2008-10 and more than twice the OECD average).

Under this scenario, the outcome would be a sharp recovery. The economic performance indicators, from consumer to business confidence to unemployment and housing finance, are all positive. But the operational leverage thesis – espoused very strongly by the Macquarie Equities strategists – doesn't rely on a strong recovery in corporate revenue.

The leverage gained from cost-cutting will be enough to potentially pump up profits in 2011. Strong revenue growth would just turbo-charge the earnings growth. Macquarie believes that investors must now focus on the underlying operating margin forecasts underpinning the current year and 2011 growth forecasts.

"Investors need to assess whether current earnings per share forecasts in FY10 (for some stocks) and FY11 are factoring in sufficient operating margin recovery."

However, investors must also be aware that thanks to the numerous equity issues – particularly in the commercial property sector – the earnings per share will suffer significant dilution.

As the corporate and economic recover gathers pace, it is inevitable that costs will again begin to rise – but that's another stage in the cycle.