First published in the fall of 2011
What is exactly the relationship between the stock market and the corporate profits? In order to shed light on this relationship, I plot quarterly data of corporate profits and end of quarter levels of S&P 500 since the beginning of 1987.
The chart shows that generally there is a strong correlation between the stock market and corporate profits. The stock market got ahead of profits during the dotcom boom of the late 1990s. There was also some divergence that started in 2004 with stocks lagging profits. Since the bottom of the financial crisis at the end of 2008, profits have risen faster than the stock market. The current divergence suggests that either profits will come down hard or the stock market will do some catching up. For the profits to come down to the current stock market level, they will have to collapse by almost 50%. Currently the profit growth is slowing down but the predominant opinion among the analysts is that profits will still rise, not collapse. If this assumption is correct, we will have to conclude that the stock market will have to go up significantly in order to restore the historical relationship between stocks and profits.
I am updating this post at the beginning of January 2013
This time I use S&P 500 operating earnings per share quarterly data and S&P index data (end of quarter values). This is the chart plotting earnings versus the index value.
The chart above shows that S&P 500 earnings are closely correlated with the S&P 500 index. The Pearson correlation coefficient is 0.83 from March 1988 to September 2012. The first chart in this blog ends in Q3 2011. At this point the earnings were ahead of the index and my conclusion was that either the index will go up or the earning will collapse. What happened actually is that the earnings flatlined and the index went up thus catching up with earnings. As of Q3 2012 (the last quarter for which we have available data), the index still lags somewhat the earnings but most of the gap existing by Q3 of 2011 has been closed. The market is more fairly valued now than it was in Q3 2011. The Q4 2012 earnings season started yesterday (Jan 8, 2013) and this season will be critical for determining the direction of the market. The estimates are for operating profits per share of $25.29. If this estimate is met, it won't do much for stocks: it will not make the market go up or down; it will most likely just support the current market level.
Conclusion: as of Q3/Q4 2012, the stock prices have caught up with earnings after lagging earnings through 2011 and now the market seems fairly valued.
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