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Every time the first revision of GDP comes out, I have been doing an article on Corporate Profits, postulating a relationship to the level of the S&P 500 and making investment decisions on that basis. This time around the material has been covered in large part by capable contributors here on Seeking Alpha.

This article opens with a graph of Corporate Profits against the S&P 500, as I have done in the past, and from there it moves along to some new ideas that incorporate prevailing interest rates and unemployment into the equation. Here is the original chart (click to enlarge images):

The Old Number

Using my prior methods, this suggests a target level of 1,450 for the S&P 500, perhaps within two years. The correlation is not that good, about .56.

The New Approach

Using quarterly data for Corporate Profits and the S&P 500, and after adjusting to current dollars using the CPI, I then develop a Logical Indicator by applying the following formula:

Logical Indicator (for S&P 500) = 6.3 * NIPA Corporate Profits/(SQRT Unemployment * SQRT Moody's Baa Interest).

6.3 is a constant selected to make the average value of the indicator equal to the average of the index. The bit with the unemployment and interest rate means that the indicator will increase as the interest rate decreases, and decrease as unemployment increases. Very logical, and it has a correlation of .80, not too shabby.

The New Magic Number

Using this approach, the equation works out to 1,362.26, round to 1,350.

What Does It Leave Out?

Here we have a nice logical indicator with an 80% correlation and an excellent fit at the low points. But there are two protracted episodes where the market and the indicator parted ways, and we may well be at the beginning of a third. Corporate profits are not getting any respect in the marketplace. To some extent the analytical task becomes one of identifying the forces that are not recognized in a three variable model.

Looking at the times when the S&P 500 has varied the most from the indicator, the tech bubble and ensuing recession stands out and needs no further discussion – those were heady days, the new era, bogus companies with no real earnings commanded impressive prices. It ended badly. There is no way to quantify irrational exuberance while it's going on. Afterward it's pretty easy.

The subsequent recovery, fueled as it was by a heady mix of deregulation and easy money, never received full market acceptance, in retrospect. It was during this period that corporate profits began to make up a disproportionate part of GDP, also when the financials became a disproportionate share of GDP. The homebuilders reported good earnings but never traded at high P/E multiples. Similarly, the most egregious of the over-aggressive financials reported hefty profits but sported low multiples.

Looking back, it is entirely possible that informed Wall Street denizens, in the aggregate, knew or sensed that there was something wrong – the housing bubble, the fraudulent mortgages, the toxic MBS, the adverse selected CDOs, the fascination with CDS profits, the excessive leverage and artful accounting. Hence the market, despite the protracted period of low interest rates and low unemployment, never fully bought into the concept that prosperity had arrived. Sleazeball Financialism is difficult to quantify, until the consequences have worked themselves through the system.

The Present Instance

That brings us to the middle of 2010, when corporate profits have fully recovered to pre-recession levels, with the cost of capital at historic lows, and yet the market continues to decline, illogically, at least according to the model presented here. Unemployment is in the equation, and won't suffice as an explanation.

The first of the month rally adds fuel to the debate. I see hyper-vigilance at the margin: every little piece of news is debated ad nauseum, traded on, and forgotten in favor of tomorrow's headlines. With so much conflicting information, and so much debate, much of it colored by politics and ideology leading up to the election, it is challenging to cut through the noise and form a coherent opinion.

A Self-Consistent Narrative

Researchers claim that the human mind ultimately resorts to simplification, basing complex decisions on a limited number of factors. With that in mind, and after putting a lot of commentary and information through the blender, here is my case, or more accurately, a narrative that is consistent with the facts as I interpret them:

The real economy is strong. It must be strong: otherwise it could not sustain the dead weight and pernicious bleeding caused by carrying a collection of bloated financial parasites around. Not to mention a fiscally irresponsible system of pork barrel politics. Real companies have been bringing real profits down to the bottom line, where they sit in the till as cash, retained earnings, the most affordable and effective form of capital ever devised, and one that is beyond the ken of many in the current analyst community. A company with retained earnings in cash has a WACC of 0.00%, try plugging that into a DCF.

These big companies never had it so good. Their cost of funds, even if they have to borrow, is at historic lows. If they want to do acquisitions, the competition is for sale, cheap. Anti-trust has faded into obscurity, a historical curiosity, relevant only as a formality before the merger goes forward. As industries consolidate, competition becomes a matter of advertising budgets, bells and whistles, not margin reduction. Labor is cheap and docile. Private equity is salivating in the background.

Unemployment may not be an impediment to corporate profits. Certainly it has not been so during the past few quarters. I have seen a number of well-reasoned articles presenting that possibility.

Ten years from now commentators will look back on this period in sorrow and wonder:

It was a time when the remnants of the US middle class were finally devastated: unemployed or underemployed, taxed to support both the indigent and the wealthy, their houses devalued, underwater or foreclosed, they were driven from a rigged casino and manipulated stock market to the bond market, where what was left of their 401k's was sucked dry. Even those who took refuge in cash were pauperized by trivial interest rates.

Meanwhile, opportunistic big money loaded up on the best American companies, finalizing an historic transfer of wealth from the middle class to the financial elite. The companies involved expedited the process with huge buybacks, in effect going private in favor of their largest shareholders. From there it was bread and circuses and fiddling while the city burned.

The Plan

The plan is, to be owning or controlling as much equity in American businesses that operate in the real economy as possible. When the process described above is complete and stocks start to revert to their true value, it is imperative to be properly positioned. If and when the gravy train rolls out of the station, I will be on board, with all my baggage. Mr. Market is a nice guy, if only he would go in and have his second evil head amputated. As it is, the best you can do is tune out the blathering and buy what's on sale.

Disclosure: Author is long US equities, lightly hedged

Source: Corporate Profits Get No Respect