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By New_Deal_democrat November 20, 2013 1:41 pm
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YoY reported corporate profits as a leading indicator for stock prices
I rarely comment on the stock market per se.  When I do, it is usually because sentiment is at an extreme, and under those circumstances, although every fiber in your body will be telling you that the crowd is right, you are almost infallibly better off betting the other way.
 
That's because, when everybody is bullish/bearish, almost all of the available money has been put into/taken out of the market.  Almost by necessity, there is only one direction in which the money can move.
 
But sometimes information typically thought of a lagging indicator, turns out to actually lead.  For example, Georg Vrba has shown that the unemployment rate, properly measured, can be an excellent leading indicator for economic upturns and downturns.
 
Similarly, while investors and advisors almost always parse "forward looking" estimates of corporate earnings, in fact the YoY rate of growth of corporate earnings already reported can be very helpful in determining the trend, and the direction, of stock prices.
 
Professor Geoffrey Moore, whose life's work in leading, coincident, and lagging economic indicators is the basis for both the Conference Board's index of Leading Indicators, and also the propriety indexes of ECRI, which he co-founded, identified Corporate Profits as a "long leading indicator," that is, a data series that leads the economy as a whole by more than 12 months.  By contrast, the S&P 500 index is a "short leading indicator," tending to turn about 6 to 9  months before the economy.  It's a fairly straightforward deduction, then, that reported corporate profits will turn positive or negative before the broad stock market.
 
And that is what we see on the graphs.  First of all, here is the YoY % change in coporate profits after taxes (red) , vs. the YoY change in the S&P 500 (blue):
 
 
Since profits are only reported quarterly, to better compare apples with apples, here is the same graph with the value of the S&P 500 averaged quarterly:
 
 
You can see that corporate 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 what analysts call "multiple expansion/contraction."  That is, an expansion or contraction of the P/E ratio makes a big difference in the comparison.  But note that, even there, the first derivative usually correlates:  an improvement or decline in the growth of profits is usually reflected in an improvement or decline of the P/E ratio.
 
With corporate profits barely positive YoY for the last two quarters, 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.  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.

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    SupperGoose's picture
    SupperGoose Posts: 1

    What accounts for the spike in CP around 2009-10?

    Thanks,

    SG

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