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By New_Deal_democrat May 31, 2018 8:01 am
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Corporate profits as a long leading indicator: Q1 2018 update

This is an update as to a relationship I have written about a number of times already.

Q1 corporate profits were reported yesterday morning.  That enables me to update several significant relationships.
 
First of all, corporate profits deflated by unit labor costs are a long leading indicator, typically peaked more than a year before the onset of a recession. But because they are reported with a lag, in the interim I use proprietors' income (already reported one month ago for Q1) as a proxy.  Now that we have both, let's compare the two: 
 
 
While profits rebounded in Q1, they failed to make a new high, even before being deflated by labor costs.  Since the last peak was two quarters prior, this long leading indicator must be treated as flashing yellow/caution.  
 
Further, this year the metric must be taken with a big grain of salt because of the effects of the tax cut. In other words, it might not be showing us what is happening in the underlying economy very well right now.
 
Secondly, if corporate profits 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.
 
 Let's look at this two ways: YoY and in absolute terms.  First, let's look at corporate profits and stock prices in absolute terms. 
 
 
This gives us some perspective on relative valuations. Although per agreement, FRED no longer shows the S&P valuations from 2006 or 2007, in a previous post I showed that when we normed the two to the same relative level as of Q4 2007, stock valuations had reached an equivalent level back in 2014. They were between 30%-40% higher than that by the end of 2017.
 
Now, here is the YoY% change in corporate profits (blue) vs. the YoY% change in the S&P 500 averaged over each quarter (red)):
 

 

Note that, averaged quarterly stock YoY stock valuations have followed the trend in corporate profits with a 2 to 3 quarter delay. That suggests that by the end of Q3, YoY the S&P averaged quarterly will be in the 2400-2500 range -- i.e., a breakout lower rather than higher.  We'll see.

 

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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