Submitted by Lance Roberts of StreetTalk Advisors
Change In Corporate Profits Leads To Market Movements
Lately analysts have been stumbling all over themselves to raise estimates for earnings growth over the coming quarters based on recent earnings announcements by various companies. However, one of the things that should be paid attention to, besides rising input prices and weakening economic variables, is the Year Over Year Change (YOY %) in corporate profit margins.
The BEA released the latest corporate profit figures today stating: "Corporate profits in the first quarter expanded to $1.450 trillion annualized-up from $1.369 trillion in the fourth quarter. Profits in the first quarter were up an annualized 25.6 percent, following a 12.6 percent drop the quarter before. Profits are after tax but without inventory valuation and capital consumption adjustments. Corporate profits are up 5.8 percent on a year-on-year basis, compared to up 11.4 percent in the fourth quarter."
The key to note here is the decline of the YOY rate of growth in profits. It has markedly declined since the peak in 2010 which historically is a good signal that we are near a market top as stocks are currently pricing in earnings and economic perfection. Of course, as we have warned in the past, it only takes a small stumble for stocks to return to fair market valuation quickly.
Currently, the market is ignoring the decline in YOY corporate profitability due to the massive amounts of artificial stimulus and most of the mainstream media is still trying to put out positive spins on slowing economic growth. Just as a reminder in December of 2007, when the media was still touting that "subprime was contained" and we would have a "soft landing in the economy", we stated that "...we are currently in or about to be in a recession." Then in March of 2008, as the media was proclaiming that we would have a "goldilocks economy" - we stated that "...we are about to be in the worst recession since the Great Depression." The evidence was much clearer then and there wasn't the invisible hand of the government supporting virtually every sector of the economy.
Therefore, while it is currently unclear whether "QE 3 to Infinity" will continue to support a flailing economic recovery or whether there is true organic recovery embedded in the bowels of the economy; it is clear is that the decline in corporate profits is something that should be paid attention to. The markets always overshoot on the upside and the downside and stocks are currently priced for economic perfection that simply does not seem to be in the cards.
Remember - it is always easier to make up a lost investment opportunity than lost capital.
Yesterday we posted a piece on the recent slide in the Year-Over-Year change in corporate profits as compared to the S&P 500. During a discussion with my friend Tyler Durden at Zero Hedge, Tyler gave me the brilliant suggestion to also compare the change in corporate profits to both the change in economic growth as well as jobless claims.
Tyler's insight was right on track as show in the chart. When corporate profits are overlaid against an inverted scale of jobless claims we find a very high correlation. What might be the explanation of this? As corporations get lean during a recessionary period profitability rises due to layoffs and cost cutting. Remember - the two biggest expenses to companies are healthcare benefits and labor costs. When they layoff employees those costs drop straight to the net income line. However, since the peak in corporate profits - companies have been slowing hiring again, unfortunately not to great degree, but enough to begin impacting profitability.
Secondly, when looking at profits compared to GDP we find, again, another very high correlation. With the economy weakening and consumer spending declining due to lack of wage growth, and now a decline in government support as well, it is not surprising to see a decline in corporate profit growth. With the consumer making up 70% of the current economic growth rate through consumption any impact on the consumer is going to quickly filter through to corporate profitability, and as we showed yesterday, stock market prices.
Finally, the evidence is mounting that corporate profits are under attack due to rising input costs through high commodity prices, weakening support from the consumer and an overall weakening state of manufacturing and employment completing the feedback loop into the domestic economy. While economists are still predicting just a slowdown in the economy before a reacceleration - my thoughts, as stated before, is that we will either see close to zero economic growth by the end of the summer or QE 3.