-- Yet another reason why I don't think this cyclical bull is over - Aug 28, 2011
-- Long Term Technicals and Macro - Jan 28, 2012
Please read the above posts as there are lots of good details and background discussion. But here are the summary points:
- Corporate Profits increase during an economic expansion (as expected)
- The stock market does not increase on current earnings, but rather expected earnings
- However the analyst community is generally very bad at forecasting earnings at tops and bottoms, they tend to lag the earnings cycle. By this I mean that they are, as a community, too pessimistic at bottoms and too optimistic at tops
- Corporate profit margins and corporate earnings tend to peak out *before* the stock market peak, as the analyst community is still forecasting earnings growth when the fundamentals have already begun deteriorating
- This is a key divergence that has happened at many market tops and is a catalyst for a market correction (usually a major one)
- Since the 1960s, the sequence has been for corporate profit margins to peak, which sets up deteriorating fundamentals, which sets up an stock market peak. This typically occurs with deteriorating fundamentals in the broader economy and happens in conjunction with a recession.
I have discussed the drivers for corporate profits in my first link above and I discuss the current macro environment and the fact that current levels of deficit spending are sufficient to support aggregate demand and in turn support corporate profits in my second link above.
And while I think we are near a cycle high in corporate profits and do believe we are currently peaking or near a peak, it is precisely because of the above observations that I don't think a 'major' stock market peak is forming here. These fundamental divergences typically take a long time (months/years) to play out. The stock market move will peter out and roll over as it becomes clear that the fundamentals have already deteriorated (which has not happened yet).
See this graph that I put together from FRED data to illustrate my point. The graph shows the trend illustrated above playing out since the 1960s. The exception being in the 1974 crash where the corporate profit margin peak was slightly after the stock market peak (a similar event can be seen in this chart):
Combined with many more observations (as detailed here) I think this cyclical bull market still has legs, and I continue to think that calls for a 'major top' formation here are misguided.