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By New_Deal_democrat April 2, 2014 9:17 am
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Corporate profits as a leading indicator for stock prices an update

Last November I wrote [http://community.xe.com/forum/xe-market-analysis/yoy-reported-corporate-... that, since corporate profits are a long leading indicator, and stock prices a shorter leading indicator, then contrary to received wisdom, reported corporate profits ought to bear some leading relationship to stock prices, and indeed they do:

"[C]orporate profits tend to turn about 12 months before stock prices.  But the relationship certainly isn't perfect.  For example, during the tech boom of the late 1990's, YoY gains in the S&P dwarfed gains in corporate profits.  The reverse happened during the last expansion: gains in the S&P badly lagged gains in corporate profits.

"This is a function of ... [P/E] "multiple expansion/contraction." ....

"With corporate profits barely positive YoY for the last two quarters [Q2 and Q3 of 2103], I wold expect that the YoY percentage growth in the value of the S&P 500 is likely to be less than 20%, on average, during the second and third quarter of next year [2014].  If there is no multiple expansion, I would expect that by the third quarter of next year, on average the S&P 500 would only be about 5% higher than it was this summer."

Now that the first quarter of 2014 is in the books, let's take an updated look comparing reported corporate profits and the S&P 500. (Regrettably, this is the last time I'll be able to use these graphs, since S&P has insisted that the St. Louis FRED delete the series since it is not paying for the information.)  

First of all, here is the relationship between the YoY% change in corporate profits vs. stock prices for the last 20 years:

Now here is the same information zoomed in on the last 3 years:

There was a marked deceleration in the YoY% increase in corporate profits in Q2 of last year that persisted through the end of 2013.  Thus, all things being equal, we ought to expect that stock prices will only be up about 5% or so YoY *on average measured on a quarterly basis* for the remainder of this year.

It certainly hasn't happened so far, and the reason is "multiple expansion" as described above and is shown in this graph normed to 100 at the stock market low of March 2009:

In 2013 and through the first quarter of this year, stock prices increased significantly more that corporate profits.

That multiple expansion might continue for quite awhile.  But a 10%+ decline of stock prices on average in this quarter or the next would certainly not be unusual.

(Final caveat:  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.)

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