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The third revision of 4Q 09 GDP includes a long awaited number – Corporate Profits. In the long run, what drives the level of the S&P 500 is profits, and NIPA Corporate Profits, as found in the GDP, serves as the basis for my mid-term target for the S&P. Here is a chart, with the S&P Index on the left and Corporate Profits on the right, in Billions$: (Click to enlarge)


The linear regressions run more or less parallel, and both the index and profits are moving upward to rejoin their trend lines.

The Magic Number – doing a scatter plot of the S&P vs. Profits, the software will generate a formula:

Corporate Profits, with inventory valuation and capital consumption adjustments, came in at 1,467.6, an increase of 7.9% from the previous quarter's 1,358.9. Doing the math, 1,467.6 X .79 + 190.36 = 1,349.76, round to 1,350.

Time-line and Reservations – A few brave souls are now forecasting the S&P to hit similar targets by year end. I would soften the time frame to something like mid-term, meaning one to two years, and express a few reservations, primarily due to unemployment, housing and interest rates.

Interest Rates – The Fed Funds rate continues at historic lows - .16% when last I checked. Moody's corporate Baa rate is a little over 6% right now, fairly stable in recent months. The relationship between interest rates and the level of the S&P 500 is not as direct and mathematically certain as some pundits proclaim, and the Fed Funds rate is arguably not the most relevant rate to use.

An extremely low Fed Funds rate is associated with a weak economy. Accordingly, the S&P 500 can remain at relatively low levels when the Fed Funds rate is extremely low. After studying the data, I see a sweet spot running from about 3.5% to 5% where the level of the S&P tends to maximize in terms of P/E. Counter-intuitively, an increase or successive increases of the Fed Funds rate from where it is will be good news for stocks. That may not happen for an extended period of time.

Housing – Housing is of concern for two reasons: 1) economic activity depends on new home construction, and 2) mortgage assets form a huge part of the foundation of our financial system. The current level of economic activity includes an extremely weak new housing market, so obviously it can be sustained without help from that source.

The banks have been recapitalized, first by pump-priming from TARP, then by the issuance of equity. The yield curve favors their continued ability to make profits and fund their remaining capital deficiencies from earnings going forward, recognizing further losses on mortgage collateral more or less in sync with their ongoing earnings. Same as it ever was.

Housing will be a drag, and argues for extending the time frame for full economic recovery forward.

Unemployment – Within limits, a docile and in point of fact terrified workforce permits improved corporate profits, due to lower wages and the ability to extract additional productivity gains from the survivors as they battle to hold onto their jobs. This essay is not about social justice, just economic reality.

Many of the unemployed were in the construction trades or small businesses dependent on localized prosperity, such as can be created by a housing boom. As such, unemployment can be expected to improve slowly.

I track a 52-week average of new unemployment claims, non-seasonally adjusted, which is declining. It correlates fairly well with unemployment, and as long as this indicator continues to point downward, my guess is that unemployment will decline more rapidly than predicted by the consensus.

As long as unemployment continues to decline, however slowly, it is not necessarily an impediment to corporate profits and accordingly to the level of the S&P 500.

Investment implications – If it takes the S&P 500 two years to reach a target level of 1,350, that still returns 7% annualized. These returns justify the risk of being in the market, but do not justify the use of a lot of margin or high amounts of leverage. Typically the index will have 6-8% peak to trough between any two quarters, so my plan is to more or less lean against the wind, whichever way it is blowing, staying about 80% in equities.

Disclosure: Long Equities, Long puts on SPY as hedge

Source: Corporate Profits Continue to Impress