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By New_Deal_democrat January 15, 2015 12:32 pm
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Corporate profits as a leading indicator for stocks: January 2015 update

This is an update as to a relationship I have written about several times in the past year.

The relationship is straightforward:  if corporate profits (deflated by unit labor costs) are a long leading indicator for the economy, and stock prices are a short leading indicator, then logically corporate profits should lead stock prices at least in terms of direction, if not necessarily in terms of volatility.  Since we now have 3rd quarter profits and unit labor costs, we have additional information for this data.

Let's look at this two ways: YoY and in absolute terms.

First, here is the YoY% change in corporate profits (red) vs. the YoY% change in the S&P 500 (blue):

We can see that generally stocks do follow corporate profits, but with a very variable lag.  Corporate profits  have only gained about 5%+ YoY for nearly two years, but stocks have been climbing closer to 20% YoY.

Of course, this really just tells us that the price to earnings ratio for stocks has increased.  That doesn't necessarily tell us that stocks are risky or overvalued.

So let's look at corporate profits and stock prices in absolute terms.  The following graph norms corporate profits, deflated by unit labor costs. (blue), as well as stock prices (red), to 100 as of 10 years ago:

This confirms that corporate profits did lead stock prices at both their respective tops prior to the Great Recession, and their respective bottoms during that recession.  It also gives us some perspective on relative valuations - as a percentage of deflated corporate earnings, stocks are roughly in the same status as they were in 2006-07.

Here is the same graph, but measuring corporate profits without deflating them by unit labor costs.  Essentially it looks the same:

None of this suggests that stocks are in any imminent danger of a crash or a bear market.  If anything, it suggests that is not the case.  While stocks may be relatively highly valued compared with corporate profits, which themselves are historically high, the fact remains that as of the 3rd quarter of 2014, corporate profits were still growing, so we should not expect stock prices, averaged on a quarterly basis, to head south right now.

Usual disclaimer:  I am an economic blogger. I do not pretend to be a securities analyst.This post contains  my 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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