Business Profits & The Stock Market

1) SP 500 net per share measured quarterly have been flat now for 18 months on both
decelerating sales growth and modest profit margin pressure. Leading economic
indicators, both weekly and monthly, are signaling an upturn in the US economy. My
coincident indicators (measured yr/yr) have moved up from a very sluggish 1.2% for Oct.
to 1.6% through year's end. Most important for the market, the Fed has embarked on a
strong new program of QE. Although economic data do not yet reflect the rise in the payroll
tax and how it might impact consumer spending, the indicators on balance point to faster
business sales and earnings growth. Good thing, too as it is doubtful investors are going to
stay interested in the market without confirmation from improving earnings. The market has
been discounting a bounce in sales and profits for over 6 months and it will become
increasingly vulnerable without stronger, positive news on the economy early this year.

2) SP 500 eps is now running about 22% above the very long trend line for earnings. This is
not at all unusual during an economic growth period. You should also note that during extended
periods of sales and earnings growth, net per share can stay well above the long term trend for
a lengthy period of time. Also note, that to have a long economic cycle, a range of balances
need to be struck between various measures of economic supply and demand. My view since
early 2009 is that the US, coming out of such a deep recession, has a good chance for a lengthy
expansion period, but note the prior post for drag factors that could upset the apple cart.

3) Earnings rarely rise or fall more than one very broad standard deviation from trend. When
net per share has risen well above one standard deviation over trend, the recession which
follows brings a larger than normal decline in earnings. SP 500 net earns. is now running about
$10 or 10% below the upper band of the long term channel. So, a strong year in 2013 would
set up a rather early warning signal about the cyclical durability of eps.

4) Return on equity at book value is now running about 15.5% for the SP 500. The earnings
plowback ratio is now running 67%. ROE% x Plowback = implied growth. 15.5% x 67%
gives you implicit growth of 10.4%. History does not suggest a bright new era. History does
suggest companies are retaining too much of earnings to make share buybacks and to do deals.
the huge writeoffs we have seen at the end of the past two expansion periods in this first
decade of the new century attest to that (Let's hope the Rio Tinto and Hewlett Packard fiascos
are not the opening wedge of a wave of new writeoffs resulting from dopey CEO empire
building). Shareholders would be better served by higher dividend payout ratios.