One can see from the above graph that corporate profits used to be an excellent predictor of future stock market returns, until about 2012. After that time corporate profits leveled out , but stocks kept marching higher. Fed easy money policies kept the stock party going. When the Fed raised short-term rates late last year, stocks took a dive. They’ve since rebounded nicely, albeit on low volume. Corporate profits started their decline early in 2015.
From the above graph it’s obvious corporate profits per GDP reached record levels compared to the last 60 years and remain well above their long-term average. It’s also arguable that corporate profits are mean reverting. Meaning they might be headed much lower. In general terms, corporate profits are determined by:
i. Capital structure – low rates lead to higher profits, but rates can’t go any lower,
ii. Taxes – tax inversions, and accounting loop holes improve profits, but the government is aggressively closing loopholes, and
iii. Employees – layoffs and compensation reductions improve corporate profits, but employee wages can’t go much lower.
The outlook’s definitely not positive for corporate profits!
That leaves investors with the Fed. Remember when the Fed said short-term rates would rise when inflation and unemployment bogeys were hit. Well, the bogeys were hit years ago and the Fed didn’t raise rates. Given last year’s rate increase experiment and the ensuing hit to markets, I can’t find any reason to believe the Fed raises rates again in 2016.
So, U.S. stock market’s should continue to party on!
DISCLOSURE: This post contains 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.