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When 3rd quarter GDP was revised upward, Corporate Profits were also reported, at a new all-time high. Ultimately, equity prices are driven by profits, although the exact correlation and relationship have been subject to debate. Investment decisions based on the expectation that the relationship would revert to historical norms have been profitable since the recovery started in 2009. Here is an update of my quarterly chart of NIPA Corporate Profits and the S&P 500:

click to enlarge


The FOMC minutes, released earlier this month, include the SEP (Summary of Economic Projections), which represents projections by the Board of Governors and the Presidents of the Federal Reserve Banks for GDP growth, inflation, and unemployment. Here is the relevant section:

Making the heroic assumptions that 1) the Fed is getting it right and 2) corporate profits will grow at the same pace as GDP, I applied growth of 3.3% and 4.0% for 2011 and 2012, arriving at a forward estimate of corporate profits. I then put that number through a formula derived from the following scatter plot:

The equation developed by the software has an R squared of .69, indicating a fair degree of credibility.

The magic number

Applying the formula, I develop a target for the S&P of 1,700, by year end 2012. That implies 19% annualized growth, sufficient to justify accepting a substantial amount of risk to remain in the market.

Reservations

The ongoing Euro crisis, the suspicion that the Chinese economy is unstable, the escalating conflict in Korea, the prospect of trade or currency wars, the ongoing housing meltdown, the lack of proper coordination of fiscal and monetary policy, the divisive and polarized tenor of political debate, and other considerations cast considerable doubt on the possibility that the markets will calmly motor along to the new highs projected by this formula.

Strategic Review

My ongoing strategy has been to apply leverage by means of options, modulating to apply less when expected returns going forward are lower, and more when they are higher. Hedging has been intermittent, applied progressively as markets increased, and removed when I guessed that markets were bottoming. Results have been pretty much what you would expect applying leverage in an upward trending market.

Contemplating the various negative possibilities, the brain goes into a kind of cognitive overload. Resorting to a simplifying theme, I will hang my hat on corporate earnings. Corporate profits drive share prices, and profits are at record highs. Share prices are well short of that level.

The trajectory of the market can be expected to be erratic. It's easy to imagine a Perils of Pauline scenario, where repetitious crises are resolved amid much theatrics and political posturing.

Given that expected returns are generous in a best case scenario, I plan to stay in the game, investing in ways that will be extremely profitable if the S&P ultimately makes its way up to 1,700. The 1,700 is a long and arduous journey, but the compass needle is definitely pointing north.

Allocation

For many years I allocated almost all of my portfolio to US equities. By March 2009, I was pretty sure that I was wrong: however, that would not have been a good time to get off the roller coaster. Now is still not the best time for corrective action. Bond markets are acting badly, and emerging market equities are now coming under clouds of suspicion.

The Fast Money crew on CNBC was saying that US Stocks might be the best place to be right now. I agree, although I will be keeping an eye out for a good time to ride off into the sunset.

Hedging

Applying leverage leads to the need to think carefully about hedging. It's more of a question of budgeting than anything else. It isn't economically feasible to hedge risk out of a portfolio and still make excess returns. Cash is a good hedge, the best place to start is to plan to hold enough cash to be able to draw for personal needs without liquidating assets at a disadvantage, also to have cash available as dry powder at market bottoms.

I normally budget 2% of my portfolio for hedging expense. The thinking is, if I put my money with a hedge fund, they would charge me 2 and 20. So I spend the 2% on hedging. I got lucky, had an attack of nerves on April 26, hedged heavily, and cashed in after the mini crash. So I had a profit on the activity instead of a loss. Being very uncertain about the outcomes through the rest of this year and early next, in September and October I spent the hedging profits to cover the portfolio against downturns through March next year with XLF and SPY puts.

The next two or three months may provide clarity about the items mentioned under reservations. Hedging is expensive, but provides the ability to stay in the market without risking losses too big to be recovered.

So far this year, my portfolio has performed on a multiple of 4X the S&P 500. Planning to reduce overall leverage to about 2X, and expecting the S&P to return 19%, for the coming year, that would produce 38% profit. 20% of that (the other half of the hedge funds 2 and 20) could be budgeted for hedging. 38% X 20% is 7.6%. That's a lot. A decision can be made during the first two months of the coming year.

Onward and Upward

As an agent representing the United States Fidelity and Guaranty Company, I can remember reading the CEO's letter to shareholders one year, and shaking my head in disgust when he summarized his plan: "onward and upward." His successor, upon terminating a much needed (and regretfully unsuccessful) turnaround effort, announced that he too was moving "onward and upward."

The point is, sometimes a simple, straightforward and optimistic approach is unworkable. Perhaps the combination of a high target for the S&P 500 with an elaborate strategy of leverage and hedging seems unnecessarily complex and convoluted. That may be. But the US equity market may very well prove to be the only game in town, with high stakes and uncertain odds.

Disclosure: Long US Equities, heavily hedged with puts on XLF and SPY.

Source: Corporate Profits: Onward and Upward