Miraculous Corporate Profit Trend Reversing?

Includes: DIA, QQQ, SPY
by: Danielle Park, CFA

[Originally published on 07/2/2014]

We have noted with some amazement and trepidation over the past 4 years as global growth weakened but corporate profits continued to soar thanks to lowered labor costs following the great recession of 2008 as well as low interest rates that fueled one of the longest, largest levered share buy-back streaks in corporate history.

While the earnings show has undoubtedly been one for the history books, the downside is that historically this trend is one of the most reliably mean reverting ever recorded. At some point cash flow, leverage limits and cost cutting can only run so far and then companies need things like sales growth to sustain record earnings growth. The turn is as inevitable as winter after fall, and with stock valuations supremely expectant of more and more earnings gains today, the below chart should give the bulls cause for pause.

At the same time, another historically relevant gauge of relative value for stocks is total market cap (aggregate $ value of the stock market) divided by annual GDP. Today the total market cap of the S&P 500 sums to more than 125% of US GDP. This can be compared with the 115% market cap/GDP ratio before the 2008 market collapse and 160% all time high on this ratio before the implosion of 2000-02. Up until 1999, Warren Buffett described this indicator as one of the most useful in assessing when stocks were overvalued and vulnerable to loss cycles. Of course that was before he became the S&P indexing, long-always, cheerleader for US stocks-at-every-price that he has become over the past 15 years. For those that still do like taking objective measurements of value at risk though, here is the chart.

Disclosure: None