Adding Corporate Profits To The Market Cap-GDP Ratio

Aug.25.14 | About: SPDR S&P (SPY)


I modified the Total Market Cap to Real GDP ratio by adding corporate profits to the equation.

Each of the previous two stock market bubbles was preceded by 2 straight quarters of profit declines, and in Q1 of this year profits declined.

When adding corporate profits to the equation I found that the ratio was above the 2007 market bubble but still significantly below the 2000 market bubble.

In this article, I will be looking at the popular indicator of the total market cap (NYSEARCA:SPY) to GDP ratio and adding corporate profits to the equation. The reason why I added corporate profits was that corporate profits are a leading indicator for stock the stock market. The chart below shows a overlay of the Wilshire 5000 Total Market Index [Red Line] vs corporate profits [Blue Line]. As you can see in chart corporate profits started declining 1-2 years prior to the peak in the market. The reason why this is relevant at this point in time is in the first quarter of this year corporate profits fell, and as I will explain in the chart #2 section below, it could be a troubling sign if profits decline again in the second quarter.

Chart #1: Wilshire 5000 Total Market Index/ Real GDP

The chart below shows that ratio of the total market index to real GDP is at all time high, and is significantly above the levels of previous market bubbles in 2000, and 2007. When looking at the chart it is difficult to try to decipher when a peak is after a long steady increase in the market cap to GDP ratio. For example, when you look at the period from about 1986 to 1990 it appeared that the ratio made a double top, which back then could have been interpreted as a sell signal. However, the chart shows that after a slight decline in the early 90s the ratio continued its upward climb for another 10 years. I believe the underlying value in stocks is determined by corporate profits, which is why I wanted to include it in the equation.

Wilshire 5000 Total Market Index/ Real GDP

Chart #2: Corporate Profits

The chart below shows the total dollar value of corporate profits. There were a couple interesting items I noticed from this chart, the first was that corporate profits peaked in Q3 of 1997, which was a little over 2 years before the market peak, and profits peaked in Q3 of 2006, which was 1 year before the market peak then. In addition, each of the previous two bubbles had one thing in common, which was two quarters in a row where corporate profits declined. This is important because corporate profits fell in Q1-Q2 1998, which was right before a major market decline, and corporate profits declined in Q4 2006 & Q1 2007, which was right before a major market decline. This is especially important for the current market because in Q1 of this year, corporate profits dropped significantly, and if corporate profits fall in Q2 as well, based on the last two bubbles a major market decline could be not too far behind.

Corporate Profits

Click to enlarge

Chart #3: (Total Market Cap/GDP) / Corporate Profits

For the final chart, I combined all the data into one formula, and it shows that we are most definitely in bubble territory. The chart shows the current ratio is higher than the 2007 market bubble. However, the ratio is still significantly lower than the bubble in 2000. I believe this measure gives a more clear picture than simply looking at the total market cap to GDP ratio.

(Total Market Cap/GDP) / Corporate Profits

Closing Thoughts

In closing, I think by combining the total market value to GDP ratio, with corporate profits paints a good picture that the stock market is in bubble territory. I will be monitoring the ratio to see if it still continues rising, and in addition I will be looking at corporate profits for Q2 of this year to see if they will rise once again after a bad weather Q1. If corporate profits do fall for a second straight quarter, I would be cautious in the market because at each of the last two bubbles, two quarters in a row of profit declines was followed by a major stock market decline within 1-2 years.


Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.