Per Corporate Profits, We Could See S&P 1,400

Includes: DIA, QQQ, SPY
by: Tom Armistead

Included with today's release of revised estimates for 1st quarter GDP were NIPA corporate profits, which came in at 1,549, an increase of 5.5% over the previous quarter. This confirms what earnings season has already demonstrated: US businesses have been making an unexpectedly strong recovery. This data forms the basis for my mid-term target for the S&P 500. 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 almost parallel, and the S&P is following profits back up toward the trend-line. If these data continue to develop favorably, investors will be well rewarded for sticking it out under today's distressingly volatile conditions.

Arriving at a target

The following scatter chart develops a linear equation for the indicated level of the S&P as a function of corporate profits.

Doing the math, 1,549 x .78 + 198.92 = 1,400. If the S&P reaches this level within two years, the annualized return holding the index would be 14.5%, figuring from yesterday's close of 1,067.95. This will compensate the investor for bearing substantial risk. The question is, how do we get there from here?

Financial Crises and Deleveraging

Fortunately there is a body of knowledge which suggests what the normal process of deleveraging in the wake of a financial crisis looks like. Back in January, the McKinsey Institute issued a report titled Debt and deleveraging: the global credit bubble and its economic consequences which contained a wealth of information on the issues which are causing so much fear and uncertainty in the markets today. It drew some attention and discussion at the time, but it will repay further review by providing a better understanding of the current crisis, much of which was foreshadowed in the information and discussions contained therein. The following chart is taken from that report:

This process can be expected to proceed more slowly that portrayed here, for the fact that the present situation is unique in that deleveraging will be occurring on a global basis, with considerable variation among countries and the affected sectors. In the US, the worst offenders at the start of the crisis were the investment banks, the household sector, and commercial real estate. The first two are about half-way to an optimal target, while commercial real estate seems to be muddling through. The US government is now in a situation where it will have to undertake the same process.

The USG has successfully deleveraged in the past, most notably from 1993 to 2001. The present status of the dollar as a safety haven may provide a window of opportunity for this to occur at a deliberate pace and in an orderly manner.

The consumer

The Federal Reserve publishes information on the household DSR (Debt Service Ratio) and FOR (Financial Obligations Ratio). Studying trends in that data, which presently extend through the Q4 2009, the most likely result is that as of the present moment the FOR is in the area of its 40-year average, and within two years of a level that has been consistent with robust economic expansion in the past.

Investment implications

When I first presented this idea, back in July of last year, data through 3/31/09 suggested S&P 1,200, a target that was hit in mid-April this year. Subsequent quarters have seen indications for 1,250, 1,350 and now 1,400. Because of the possibility that global deleveraging will proceed at an uneven pace, and may operate to impede economic growth for two or more years going forward, I would tend to push the time frame out toward two years for S&P 1,400. But the return implied by that target – 14.5% annualized – makes US equities an attractive investment for those who are optimistic about the strength and resiliency of this nation.

Disclosure: Long US Equities