Profits and the Economic Outlook

Be Your Own Economist ®

The Lehmann Letter ©

Wednesday
November 14, 2007

Profits and the Economic Outlook

Yesterday’s stock-market surge reminds us that it may not be all down hill from here. Today’s New York Times ran a front-page opinion piece by David Leonhardt, http://www.nytimes.com/2007/11/14/business/14leonhardt.html?_r=1&oref=slogin, suggesting there may be a silver lining to all that bad news about oil, credit markets and housing.

So how do we make sense about what’s going on? What are the bed-rock fundamentals that should concern us?
Let’s return to a point made in Monday’s posting: The stock market can’t rise over the long haul unless earnings grow. If profits head south, the stock market can’t be far behind.

That’s also true for the economy. If earnings continue to grow, the economy will move up with them. Should profits reverse course and head south, there’s trouble brewing.

Consider again the relationship between profits and the stock market as shown in the chart below. [Go to http://www.beyourowneconomist.com/ (click on Seminars and then Charts).]

S&P 500

















Earnings and the stock market move in tandem. If the market gets out ahead of earnings, as happened in the dot.com bubble, a sharp correction awaits us. That’s what happened in 2000 – 2002. Cautious investors remember, and in the last five years investors have not bid the market up faster than the growth in earnings. Quite to the contrary, you can see that earnings pulled ahead of the market lately. Investors have held back and not repeated their late-1990s error. If earnings should now deteriorate, investors will bail out.

Now look at the charts below. They portray profits and profit margins.

Profits

















Profit Margins

















First, note profits’ strong growth in the 1990s and their stumble at the end of that decade. There WAS a warning (profits stopped growing in 1997) that investors did not heed before the 2000 – 2002 crash. Then note especially profit margins’ extraordinary performance in the 1990s before their collapse at the end of the decade. (Profits = profit margins X sales volume.) Profit margins dragged down profits between 1997 and 2000. That was a bad omen for the economy as well as the stock market.

Then note the remarkable recovery of both series. Profits have tripled since the 2001 recession. No wonder the stock market and the economy have done so well. You can also see that from 2000 to 2005 profit margins recovered all the ground they lost in the late 1990s, and then popped up to a new record high in 2005. They were responsible for profits’ strong performance.

But now it’s plain to see that profit margins have recently taken a jog south. If that trend continues and turns into a margin melt down a la the late 1990s, profits will head south too. The stock market and the economy won’t be far behind.

What could lead to that? A collapse in residential construction and a reduction in consumer expenditures stemming from the real-estate recession might. That could drag profits down, and the stock market and the rest of the economy with them. That’s why there’s such concern about these indicators right now. The stock market and the economy await their cue from profits, which could be jolted by weak construction, strong oil and bad credit.