Profits As A Leading Indicator Of The Stock Market And Economy

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Includes: DIA, QQQ, SPY
by: Charles Bolin

Summary

Profits are a good leading indicator of the stock market 4 to 8 quarters into the future.

As profits decline, businesses often cut costs and defer investments contributing to a slower economy. Stock valuations often rise or stock markets fall.

Surveys of economists show a probability of a recession of 20% by 2017. I believe that is low.

Introduction

The chart below shows measures of corporate health such as operating surplus, income, profits, and cash flow usually start falling 1 or 2 years before a stock market decline or the start of a recession. According to FactSet, the 1st quarter of 2016 was the fourth quarter of negative profit growth. This article evaluates profits as a leading indicator of the stock market and economy.

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Year-over-year growth of profits as measured on FRED using Corporate Profits after Tax with Inventory Valuation Adjustment and Capital Consumption (CPATAX) without the impact of share buybacks has been flat or negative since 2013.

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Relationship Of Profits To The Stock Market And Economy

At the GB Capital website, they state "Both, NIPA profits and S&P 500 earnings, strongly correlate at the major macro turning points to the S&P 500 USA stock market index and other broad U.S. market indices including Dow Jones, Russell 3000, Wilshire 5000, MSCI USA Index and NYSE Composite."

Chris Sheridan wrote (June 2014) in Financial Sense that "BEA's measure of corporate profits peak on average over a year before the stock market peaks and over two years before the onset of an economic recession." He had another article, "Corporate Profits and Market Crashes" (May 2014) which goes into the detail.

The effects of profits on the stock market are well known as follows. Jeff Gundlach was attributed with describing the relationship of profit margins to the stock market in "Why the S&P 500 Net Profit Margin May Predict a US Recession" (Dec. 2015). Sam Ro wrote a good article (Oct. 2015) for Business Insider describing the relationship between declining profit margins and recessions. John Hussman has described (2009) the relationship between the year-over-year change in operating earnings and the YoY change in nominal GDP. "The Stock Market As A Leading Indicator: An Application Of Granger Causality" (1996) finds evidence that the stock market typically leads the real economy by up to 3 quarters.

Corporate Indicator

I have a corporate indicator in my investment model that is a composite of 12 sub-indexes including income, profits, operating surplus, real output, taxes, sales, and net value added. This Corporate Health Indicator is compared to 9 other indicators using correlation 10 months behind and forward. There is good correlation for Final Sales of Domestic Product, Production, Credit Markets, Income, Technology, Labor, Construction, Confidence and Technical (stock market) several quarters into the future. If corporations have declining profits, they will tend to reduce costs and investments which will contribute to a slowing economy.

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My Corporate Health Indicator tends to lead my Leading Indicator which is a composite of the Philadelphia Fed USSLIND and Conference Board leading indicators.

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It also leads the Labor Indicator. If corporate profits are declining, then businesses will most likely tend to tighten their belts and defer hiring or reduce jobs.

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This can be seen in the slowdown in the year-over-year improvement in Initial Claims and the slowdown in growth of Temporary Help Services.

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Conversely, several composite indicators have a high correlation to Corporate Health several quarters in advance such as Potential GDP, Valuation, Monetary, Dieli and Margin Debt.

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My version of Robert Dieli's "Mr. Model," tends to lead my Corporate Health Indicator as does Monetary Policy.

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Validation

To validate my Indicators and that Profits do have a leading impact on the stock market and economy, I drew Corporate Profits, Wilshire Large Cap Index, Industrial Production, Total Business Sales, and National Income: Compensation of Employees back to 1982.

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I then ran scatter plots with r-squared against corporate profits. If profits go down, the oil companies, for example, will tend to stop bringing new production on line. When profits are declining, bonuses and pay increases may be smaller.

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Conclusion

Profits are declining and valuations are high. In "Measuring Risk In The Economy and Markets," I describe some of the risks that we are facing now. I believe the probability of being in recession prior to the end of 2017 is higher than the 20% reported from surveys of economists.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not an investment advisor. Investors should do their own research or consult with an investment professional.