Stock Prices Don't Lead Corporate Profits - It's The Other Way Around

Includes: DIA, QQQ, SPY
by: Hale Stewart

Here is an update appropriate for the end of the first quarter.

One insight generated by making use of overall leading economic indicators is that, if corporate profits are a long leading indicator and stock prices a short one, then it stands to reason that corporate profits actually lead, rather than follow, stocks, at least when measured as a quarterly average. If it wasn't clear before, then this graph from Scott Grannis, aka Calafia Beach Pundit, dispels all doubt:

While I'm not in the business of giving investment advice, even a cursory look suggests that typically there is still a lot of upside in most bull markets even after corporate profits have peaked!

But to the point. Since Q1 2016 is ended, let's update this relationship, showing stock prices (blue) as compared with corporate profits (red), with both normed to 100 as of the last stock market peak in Q4 2007.

As expected, corporate profits took off first after the Great Recession, and stock prices caught up. Corporate profits moved sideways in 2012-13, and then improved in a very gradual manner until declining in the last two quarters. Once stock prices caught up in 2014, they have closely tracked the corporate trend.

Here is the same information as YoY% changes:

Again, the leading/lagging relationship is clear, although there can be YoY divergencies for extended periods.

This tells us that stocks remain as richly valued as a share of corporate profits on a relative basis as they were in Q4 2007, their previous peak. But what about corporate profits themselves? A comparison of corporate profits as a share of GDP is very instructive:

As a share of GDP, corporate profits in the last 10 years, outside of the last recession, have been at or near a 70-year record as a share of GDP, before turning down sharply at the end of last year.

Here is a close-up of the last 6 years:

As an aside, in a democracy, this kind of imbalance is going to create blowback - and it has, in the form of Donald Trump on the one side and Bernie Sanders on the other.

Leaving aside this important equitable consideration, the above shows that:

1. Stocks are richly valued compared with corporate profits, and

2. Corporate profits themselves, which were at extreme levels as a share of GDP, are still relatively high compared with the long term.

Under those circumstances, although there is always wiggle room, it does not seem likely that stock prices will outperform corporate profits in the near future, and corporate profits themselves have more room to fall than rise.

New Deal Democrat,

Disclaimer: I am an economic blogger. This post contains opinions and observations. It is not professional advice in any way, shape or form and should not be construed that way. In other words, buyer beware.