Gary Jakacky's  Instablog

Why not? Because over the long haul--- the time frame over which the biggest profits are made---there is no relationship between corporate profits as a % of GDP, and the behavior of a broad index of stock prices.

Lets look at the evidence. Below is a chart showing profits as a percentage of GDP in the Post WWII era.

(click to enlarge)

As a statistician and analyst, when I look at this chart, I see four periods of time where profit margins fell noticeably and for prolonged periods:

• 1951 to 1954, which was part of a general post WWII decline in profitability that persisted throughout that decade;
• 1965 to 1971, perhaps due to the effects of the Vietnam War, inflationary pressures and surtaxes,
• 1979 to 1986, perhaps due to tight money in the emerging Volcker era, and
• 1996 to 2000, perhaps due to globalization and opening of third world markets.

Sure there were other zigs and zags, but these are the big ones which stand out.

Now lets compare these four lengthy intervals of punk profits with performance of the Standard and Poors 500 Index over these same time periods. You will want to enlarge the chart so you can see the selected periods I talk about.

• 1951-1955: During these years corporate profits were sliced in half! Yet look at Standard and Poors index during this period..almost a steady advance, except for a few down months in 1953. (I was born in 1953...as good an explanation for the selloff as any!) If you prefer the Dow Jones Industrials figures, the index climbed from 200 to almost 500 over this span. Nice work, if you can get it, as Gershwin would say.

(click to enlarge)

By the way, the pattern thru the rest of the fifties continued to show no relationship. An investor in those Eisenhower years who was waiting for profits to return to their postwar peak sat out two powerful bull markets from that era! So did investors who were pining for traditional blue chip dividend yields...but that is a topic for another article.

• 1965-1971: The lesson here is similar to that of the previous decade. Profits slumped to postwar lows, and yes, the overall performance during this period was poor. But investors focusing strictly on profits missed a 2 year bull market from 1966 to 1968.

On the other hand, profits surged in the early to middle 1970s. But what did investors have to show for it? Those years were no kinder to investors than the previous 6 years had been! Stock prices hit 20 year lows in late 1974, even though profits as a % of GDP were still higher than a few years earlier.

• 1979-1986: this is my favorite example and half the reason I wrote this article. In this 'Volcker era,' profits fell steadily to what appears to be (from our vantage point) generational lows. Yet, over this time span prices broke out of their fourteen year consolidation and soared to new highs as inflation and double digit interest rates were tamed.

Much like the 1950s, there was a bear market in the early Reagan years, in this case as monetary discipline bit the economy; but once this was over it was full steam ahead, even as profits continued to fall!

• 1996-2000: I have chosen to save the best for last. Please don't tell me I have to tell you what happened to stock prices in this period! Profits as a % of GDP went straight down...and stock prices went, um....straight up. Et tu, Nasdaq and countless world indices.

Now, some will claim that it is the extremes in margins which should attract your attention for investment purposes. I do not disagree with this view, but i wish to point out that these extremes come so far apart that even a long term investor could wait decades before a position should be taken.

For example, the 1950s peak was not surpassed until 2006! Please show me someone who went this entire time without selling.

And how many investors are going to wait for the 1984 trough before buying stocks again?

There are many factors which affect stock prices: interest rates, debt levels, technological breakthroughs, political events, secular trends in PE ratios and other multiples, etc. A singular focus on profits can be disastrously simplistic for the long term investor.

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

Additional disclosure: Always pays off to be long term bullish!