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By New_Deal_democrat January 8, 2014 9:23 am
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Corporate profits for 2013 suggest a pullback for stocks in mid-2014

As I’ve mentioned previously, I very rarely comment on the direction or level of the stock market per se.  Typically I just discuss it in the context of being a short leading indicator for the direction of the economy.

But occasionally there is something to say, and given a recent flurry of speculation about the possibility of a stock market “crash,” now is such a time.

 While I don’t see much possibility of a “crash,” there are several indicia by which the current valuation of stocks can be questioned.

 Let me start with an observation I made a couple of months ago:  that, contrary to popular wisdom, stock prices do not anticipate corporate profits.  Rather, stock prices tend to follow the trend in corporate profits with a lag period of about 9 to 12 months.  This follows from the research showing that corporate profits are a long leading indicator for the economy, tending to peak 12 or more months before the onset of a recession.  Here’s one of the graphs I ran, to refresh your memory:

 

Which brings us to the current level of the S&P 500 vs. corporate profits.  In both Q2 and Q3 of 2013, these grew at about 5% to 7% YoY. If stocks trade at the same price to earnings ratio, then the historical record suggests that they should trade at about 5% to 7% higher, as a quarterly average, in Q2 and Q3 of 2014, then they did in summer 2013.

 The below graph shows the quarterly average for stocks in 2013, with the red line indicating a 6% increase over Q3 earnings.  As you can see, in Q4 stocks traded, on average, only slightly above that line.

 

Now look at the same red line as compared with the daily value of the S&P 500 through December 31, 2013:

 

The closing value of the index at the end of 2013 was about 10% above that anticipated quarterly average for Q2 and Q3 of 2014.

 But of course, this implied that there will not be “multiple expansion,” or in layperson’s terms, greater enthusiasm for owning stocks.

Is there a reason we should expect multiple expansion?  The below graph shows the inflation-adjusted value of the S&P 500:

 In the last several months, this value has soared to near its previous record highs.  A further increase would imply even greater stock valuation than at either the dotcom peak (34.5), or the pre-great recession peak.  Although we aren’t close to the p/e ratio of stocks at either of those peaks, with a current p/e of 18.7, that isn’t cheap, either.

 I should note, contrarily, that while insiders were selling briskly in October, that seems to have calmed down, despite the advance.

 While typically a “crash” involves the unwinding, whether human or mechanical, of leverage, and I don’t know of any particular huge such leverage, a bear market of a 20% loss over a quarter or two is hardly uncommon.  And might be expected.

 Usual disclaimer:This posting 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.

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