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By New_Deal_democrat December 1, 2017 9:40 am
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Extreme measures? An updated look at corporate profits vs. stock prices
This is an update of prior posts on this subject.  One insight generated by making use of overall leading economic indicators is that, if corporate profits are a long leading indicator, and stock prices a short one, then it stands to reason that corporate profits actually lead, rather than follow, stocks, at least when measured as a quarterly average.

Corporate profits have now been reported for Q3 2017.  Let's update this relationship, showing stock prices (blue) as compared with corporate profits (red), with both normed to 100 as of the last stock market peak in Q4 2007:   


As expected, corporate profits took off first after the Great Recession, and stock prices caught up.  

Because FRED's agreement with S&P only allows them to include the last 10 years of data, before I go further, though, let me post the exact same graph as it existed two years ago:

In Q3, while unadjusted corporate profits made a new record (blue), adjusted for unit labor costs (red) which is the metric identified by the late Prof. Geoffrey Moore as leading, they did not:

Generally, corporate profits have meandered sideways since 2012-13. Meanwhile stock prices caught up to profits in 2014, in the last several years they have outpaced them, so much so that  by that measure the S&P 500 has been more richly valued in the last several years ago than even at the 2007 peak.
While profits haven't materially declined, meaning there is no reason to believe that the cyclical "top" is in for the S&P 500, are they nevertheless at or near an extreme? 
Lots of things can of course cause a bear market, but for me to think that stock prices are at an extreme -- where the chances are very high -- I would want to see stocks in the top 10% of so of all time p/e's, and/or the top 10% of profit to GDP margins, AND ALSO the underlying denominator (GDP or earnings) near an extreme as well.  In other words, not only is the price being paid relative to earnings or profits high, but the underlying earnings or profits themselves are at a level that is likely to be an outlier in the longer term secular sense.
The Washington Post reported earlier this week that GDP has finally returned to trend after 10 years of underperformance:
Meanwhile, since 1995, corporate profits as a share of GDP have been higher than at any time in the previous 50 years, with the exception of bottom of the two subsequent recessions (h/t Doug Short):
They have exceeded their 2007 peak in that metric, although they are still about 10% below their 2000 dotcom era all-time peak. [Parenthetically, this is emblematic of the economic inequality in the US, and the state of the political landscape.  The kind of backlash that is being stoked is potentially enormous.]

So the price to GDP ratio is near an extreme, but the underlying GDP isn't at an extreme -- although it is relatively high compared with the last 10 years.

The mirror image situation obtains with regard to earnings.  As we saw in the first set of graphs above, corporate earnings are near all-time real highs, but have not broken out to new extremes in the last several years.

Meanwhile the price to earnings ratio has increased (h/t Ed Yardeni):
but it is not yet at the extreme of 2000 or 2007.
One final item: the advance-decline line is an overly sensitive measure to the downside. I would expect it to decline before a top in the big averages. Although I can't find it online at this point, the a/d line started to decline in late 1998, and continued to decline precipitously through 2000
Further, as the below graph shows, it turned a few months before the top in valuations in 2007:
It isn't doing so now.
To recap, price to GDP is near an extreme, but the underlying GDP is not at an extreme (but is not below trend either).  Price to earnings are somewhat rich but not at an extreme yet, but the underlying earnings are and have been for the last half decade near extreme levels. On the other hand, they aren't flashing red alarm signals. Consider the levels as being at "yellow/caution."
DISCLAIMER: I am a data nerd and economic analyst,. I primarily care about how the economy affects the well being now and in the future of average americans. I am not an investment advisor and this is not investment advice!
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