A Macro View Of Corporate Profits, And The Stock Market Offers Helpful Insights – Seeking Alpha

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Observations from a macro level demonstrate that the stock market generally follows the ups and downs of corporate profits. However, there are times when the market unhinges from profits. In fact, every business cycle examined in this article had its own period of “irrational exuberance,” with the dot-com bubble being the most extreme example.

Outside of irrational periods, the stock market, with some lag, is mostly in lockstep with the general upward and downward trends of corporate profits. For investors, this is useful information. Recognizing periods when stock market changes faithfully lag profit changes, investors can better assess pending market movements.

Conversely, it is equally important to know when overly optimistic investor sentiment feeds on itself, driving the stock market upward, even as profits fall. Not surprisingly, history shows that profits have a habit of eventually snapping unfounded investor exuberance, bringing the market back to reality.

On the charts shown throughout this analysis, the S&P 500 data has been adjusted to quarterly averages, which provides a better comparison to quarterly profits. The measure of corporate profits that I am using is referred to as “production profits” by the BEA. Production profits have been adjusted by the BEA to eliminate some of the paper profits that can be gained from inventory valuation and depreciation methods.

Before looking at the current business cycle, I will examine the two previous ones: 1990-2001 and 2001-2007. Looking at the past makes it easier to gauge the rationality of the current cycle.

1990-2001 Business Cycle

Chart 1 shows adjusted corporate profits and the S&P 500 from 3Q 1990 to 2Q 2001. This business cycle started after a relatively mild recession, which, at its worst, using quarterly averages, lowered the value of the S&P 500 by about 7%.

At the beginning of this business cycle, there was modest growth of corporate profits and the stock market. However, as shown within the red rectangle, profits showed an increased rate of growth starting in 1Q 1993. Despite this positive increase, the stock market dropped in 1994 after long-term interest rates jumped dramatically (read historical NYT article here). The stock market grew at a lower rate of increase than profits until 4Q 1994, after which growth accelerated. The acceleration in stock market growth lagged the acceleration in profit growth by nearly two years.

Corporate Profits 1

It is obvious that profits and the market are not in perfect lockstep. However, the accelerated growth rate in profits starting 1Q 1993 is a significant trend that clearly leads the accelerated growth in the stock market starting in 3Q 1994.

The next chart shows the period when the stock market became completely unhinged from profits: the infamous dot-com bubble. Corporate profits dropped in 1Q 1998 and continued a general downward trend until 4Q 2000. All the while, the stock market was giddily on its way to new highs. The investor groupthink that drove this market was based on the belief that the new dot-com business model could succeed with nothing more than an online presence and buckets of cash. The spectacular stock market crash that followed confirmed that investor sentiment built on groupthink was no match for real profits.

Stock Market 2

Another pattern shown here that is noticeable in later business cycles is that the period of irrational exuberance came later in the cycle, after an extended period when corporate profits and the stock market had trended closely, at least from a macro level.

2001-2007 Business Cycle

The next business cycle, 1Q 2001 to 4Q 2007, also followed a relatively weak recession, one that lasted only two quarters.

As shown in Chart 3, the carnage in the stock market from the burst dot-com bubble didn’t end until nearly two years after the end of the recession. But, here again, the influence of profits is seen. Profits grew steadily after the recession. Faced with this reality, investor analytics and common sense eventually shifted overall sentiment from sell to buy. Starting in 2Q 2003, the stock market rate of growth was similar to that of corporate profits. The two tracked closely until profits peaked in 3Q 2006.

As can be seen, there are a number of market corrections from 2Q 2003 to 3Q 2006, which probably led to some doom and gloom forecasts. The most notable decrease occurred in 3Q 2004, when several key tech companies announced lower-than-expected earnings and oil prices had started to rise. However, helped by a 2004 presidential election outcome that seemed to please investors, and the fact that GDP had averaged over 3% during the previous six months, the market rebounded the next quarter. I point this out because over short periods any number of economic hiccups can make the market jumpy and decline even when profits are increasing. This is why the macro view is useful. The strength of the profit/market relationship is easier to recognize.

Corporate Profits 3

In Chart 4, after 3Q 2006, we see the stock market decoupling from profits. What is notable about this period of irrational exuberance is that the housing bubble, gauged by building permits and existing home sales, had popped in 1Q 2006. Until 2Q 2007, a majority of investors shrugged off a free-falling housing market for five quarters and falling profits for three quarters. But, even after 2Q 2007, the market stayed relatively flat for two quarters before it fell sharply in 1Q 2008.

Stock Market 4

Once again, we see the strong influence of profits throughout most of this business cycle. Rising profits at the beginning of this cycle eventually overcame investor panic, leading to a three-and-a-half-year period in which profits and the market moved upward and generally in tandem. This was followed by a new edition of irrational exuberance, which eventually gave way to economic reality as investors finally heeded declining profits, the housing crisis, and a dying business cycle.

Current Business Cycle

The current business cycle is far more complex than the previous ones we have examined. To examine this period, I have broken it into six distinct transition phases. Note throughout the business cycle the consistency of the stock market lagging corporate profits.

Phase A: In the depth of the recession, 4Q 2008, profits bottomed out. One quarter later, the stock market did the same.

Phase B: From 1Q 2009 until 4Q 2010, profits and the market trended upward at similar rates. Profits peaked in 4Q 2010. The stock market, lagging profits by two quarters, peaked in 2Q 2011.

Corporate profits 5

Phase C: Corporate profits declined for one quarter, 1Q 2011. Lagging the drop in profits by two months, the market declined for two quarters starting 3Q 2011.

Stock market 6

Phase D: Profits rebounded in 2Q 2011 and continued upward for three quarters. The market, lagging by three quarters, started moving upward in 1Q 2012.

Corporate profits 7

As shown in Phase D, the first quarter of 2012 was an interesting transition point, as profits essentially flattened until 4Q 2013. However, during this same time period, the S&P 500, measured in quarterly averages, increased from 1,226 to 1,769, a 44% increase. This appears to be this business cycle’s brand of irrational exuberance. However, a good argument can be made that the market was not completely unhinged. Although corporate profits flattened starting 1Q 2012, from 2Q 2011 until 4Q 2013 they increased 24.5%. In addition, during this period, GDP grew an annualized average of 2%, which has been normal growth for this business cycle. And thanks to the Fed, low interest rates aided investor optimism. For these reasons, and perhaps others, there is some rational for the exuberance.

Phase E: In this phase, we see the market reconnecting with corporate profits. Profits declined in 1Q 2015 and were followed two quarters later by the stock market. The drop in profits continued until 4Q 2015.

It was during this phase that the “earnings recession” occurred. This is a likely reason that the exuberance evident in Phase D was correctly tempered.

Stock market 8

Phase F: Corporate profits rebounded in 1Q 2016 and were followed a quarter later by a rebound in the stock market. Based on quarterly averages, from 1Q 2016 to 2Q 2017, the S&P 500 increased 30%. Corporate profits increased 12% from 4Q 2015 to 2Q 2017.

However, from 4Q 2016, the stock market has increased nearly 10%, while corporate profits declined nearly 2% (red rectangle). These facts lend some credibility to the “Trump bump.” Consumer and small business optimism have jumped up under the Trump administration without any significant change in the economy. Why shouldn’t investor optimism see the same level of increase despite weakening profits?

Corporate profits 9

During most of this business cycle, the relationship between profits and the stock market has been relatively tight. The lag has been between one to three months. However, there have been periods where the relationship weakened, significantly in Phase D and most recently after 4Q 2016.

Is Today’s Market Rational

In Chart 10, I’m showing the S&P 500 with monthly averages to make it clear what the market has done over the first two months of the current quarter. As I have already noted, although corporate profits have declined 2% since 4Q 2016, the stock market has seen above average growth during that time. But the market did moderate in July and August.

In September, the market average is up, 2,469 versus the August average of 2,456. However, August started with an average similar to September, so it is conceivable that the average could decrease as the month progresses. On the other hand, nothing scary has been reported in recent economic news or the expected earnings for the third quarter. Previous periods of exuberance have been driven by sentiment and not real profit growth. This bears watching.

Corporate profits 10

Conclusion

A macro view shows meaningful patterns that can put the here and now into perspective for investors. For example:

  • When irrational exuberance has not taken over the market, general trend movements in the stock market generally lag general trend movements in corporate profits.
  • Despite periodic corrections, as long as profits are generally favorable (and the evidence shows that even flat profits have been viewed favorably), the stock market will continue on a general upward trend.
  • Periods of irrational exuberance tend to happen later in a business cycle, after periods in which corporate profits and the stock market have increased in tandem.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.