Why U.S. Corporate Profits Could Drop in the Next Few Quarters

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 |  Includes: DIA, QQQ, SPY
by: Zhong Jin

Friday's Wall Street Journal reported that the net worth of U.S. households increased by more than $1,020.5 billion in the third quarter in 2010 based on the Fed’s flow of funds accounts. The increased net worth is mainly due to rising stock market wealth. Chart 1 shows the relationship between the quarter-to-quarter change rate of S&P 500 index and the change of the net worth of U.S. households. The two statistics basically move together. Given the strong stock market in the fourth quarter so far, we can expect that the U.S. households’ net worth is going to rise again in this quarter.

Chart 1: Net Worth of U.S. Households and S&P 500
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How big is the wealth effect of the rising stock market? Academic studies generally put the wealth effect of the U.S. stock market somewhere around 6 cents on the dollar. Therefore, a $1,020.5 billion increase of household net worth implies a $20.41 billion increase of personal consumption per month in the third quarter of 2010, approximately 0.15% of U.S. GDP. Every 1% increase in S&P 500 index compared to the previous quarter usually implies a more than $100 billion increase in the net worth of U.S. households in recent quarters. The S&P index so far has risen by more than 8% this quarter. The increase of the net worth should be around $1,000 billion now. Wealth effects from the increased net worth would be about an increasing consumption of $60 billion this quarter. This should be good news for retailers and entertaining industries.

However, increasing consumption today has less ability to lift wage and employment. The following chart shows that every dollar of consumption now only increases wage by 62 cents, compared to the average 70 cents before 2000. The multiplier effect of growing net worth and increasing consumption on economy has been dropping. Final demand is still lacking in the U.S.

Chart 2: Ratio of Wage to Consumption (click to enlarge):

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The corporate profit margin is in a much better shape. It almost goes back to the pre-recession level.

Chart 3: Ratio of Corporate Profit to Consumption (click to enlarge):
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But the growth rate of corporate profits is dropping, which is the reason that nonfinancial companies in the U.S. put 7.4% of the total asset in cash-the largest share since 1959.

Chart 4: Nonfinancial Corporate Profit Growth (click to enlarge):
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Chart 5: Ratio of Liquid Asset to Total Asset (click to enlarge):
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Apparently U.S. companies are pessimistic about future due to lack of demand. U.S. companies have to look for new approaches to boost profit growth rate, otherwise their profit margins will drop in the next few quarters. Demand for borrowing money will continue to be low given that companies have a huge amount of cash and fewer high-return investment opportunities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.