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Keep Your Powder Dry

Columnist

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David Raub
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To be wise investors, we should acknowledge that predicting where stock prices will be in three months or three years is impossible—not that millions of investors have given up trying.

We can get a pretty good idea, however, where stock prices are likely to be headed by carefully following corporate earnings. In their essence, stocks represent shares of a business enterprise’s profits. If you own a piece of Company A—and if you can easily sell that ownership to someone else—it follows that the market price of that ownership should closely track the profits Company A is making.

Let’s examine the history of corporate profits as reflected in data series kept by the U.S. Department of Commerce, Bureau of Economic Analysis (BEA). Since the outset in 1947, U.S. corporate profits tracked by the BEA have grown at a compound annual rate of 6.4 percent. Part of this growth represents the general inflation we’ve experienced over those six decades; the remainder represents “real” growth in corporate profitability.

You can explore the data yourself at http://www.bea.gov/National/nipaweb/SelectTable.asp. From the myriad data series available, select Table 1.14, then examine line 33, which shows profits after income taxes for all corporations. The BEA data is derived from corporate income tax returns. Since taxpayers rarely overstate their income on tax returns, we can assume that few corporations are padding the statistics to mislead current or potential shareholders.

To determine how closely stock prices have tracked the BEA corporate profit data, we ran what’s called a “regression analysis,” which is a commonly used statistical method for exploring relationships between data series. We find that, over the past six decades, there’s a very close correlation between stocks prices, as measured by the S&P 500 Index, and the BEA corporate after-tax profits.

For those who are statistically minded, the correlation has an “R-Square” of 0.91, which is very close to the maximum correlation of 1.00. This means that, over the period examined, 91 percent of changes in the S&P 500 Index can be “explained” (accounted for statistically) by changes in BEA corporate profits.

How has the current financial meltdown affected corporate profits? Data for the fourth quarter of 2008 was released at the end of March, and it wasn’t pretty. Profits for Q4 declined almost 42 percent, the worst quarterly drop since the data series began.

BEA corporate profits are now down 53 percent from their recent peak in the third quarter of 2007. Over the same period, the S&P 500 Index is down 47 percent, so, if anything, the market has slightly under-reacted to declining corporate profitability.

Let’s see how profits and stock prices have behaved in the most recent severe market downturns, the “double recession” of 1980 and 1982 and the bursting of the tech bubble in 2000-2002. In the first period, corporate profits began slipping at the end of the second quarter of 1979, a decline that accelerated in 1980. After abating somewhat in 1981, the decline accelerated again in 1982. By the end of 1982, corporate profits had declined about 37 percent from their peak four years earlier. The overall decline lasted 15 quarters.

During the tech bubble, profits began to slide at the end of 1997, recovered somewhat in 1999, but fell again in earnest until the last quarter of 2001, at which point they were 40 percent below the late 1997 peak. This profit decline lasted 17 quarters.

Where are we now? Profits have now declined more than they did in either 1979-1982 or 1997-2001, so perhaps we’ve already reached the bottom? Let’s not be hasty—we aren’t even half way through the length of the profit declines we experienced on these two prior occasions.

Even if the recent government fiscal and monetary stimulus succeeds in halting the profit downtrend, remember that, in both of the above recent severe market downturns, profits recovered somewhat for a few quarters, only to slip again (and more severely) later. And today, in contrast to the profit recoveries that began in 1983 and 2002, Congress and the Administration are decidedly less inclined toward rewarding investment capital. It remains to be seen whether the recently enacted stimulus package will actually help the private sector or amount to “bleeding the patient,” the ancient and widely used, but now discredited, medical practice aimed at curing illnesses by removing “excess” or supposedly “stagnant” blood from the patient.

Here’s another useful observation we can make from the profit declines of the 1979-1982 and 1997-2001 market downturns: If one had waited until there had been four consecutive quarters of profit gains in 1983 and 2002, he would have missed little of the ensuing major rallies in the stock market.

There’s no reason today to hurry back into the equity markets. Keep at least some of your powder dry until we again see real gains in corporate profits.