Corporate Profits

The indicators I track to gauge the outlook for non-financial profits
have nosedived over the past 6 weeks. Physical output has
deteriorated and pricing power has weakened substantially. Q 3
'08 will reflect just a minor portion of the weaker outlook. But
Q 4 '08 and next year's Q 1 will likely reflect more fully the
damage to profitability underway. There are still pockets of
strength offshore, and a weaker yr/yr comparison for the US $
will help, but broadscale earnings weakness is presently in the
cards. Financial sector profits remain dismally low as loan losses
and seccurities writeoffs remain large. Q 4 ' 07 was a disaster
for the financial sector and perhaps the current quarter will not
be as bad.

Corporate profitability has improved significantly since the late
1980's, and there is no evidence yet that profitability is set to
retreat to very long term norms. However, the next few quarters
could well test the longer term trend, especially since pricing
power has been such a strong feature of profits growth over the
past half dozen years ( oil & gas and basic materials especially).
To be more specific, SP 500 quarterly profits need to hold well
above the 15.0 level for the next several quarters, as that is the
low end of a broad range trend band in force for over 20 years.
I dwell on this because if it looks like yearly profit growth is set to
slow from 8.5% on average to a lower rate, then investors will
ultimately adjust the index price until the dividend yield is
high enough to offer an attractive rate of total return. I bring
this up now, because many corporations have already done so
many of the tasks that can reasonably be done to enhance
profitability.

It has been my view that the recent sharp decline in stock
prices has not been irrational, but has been a reaction to a
fast turn for the worst in the outlook for profits in the months
ahead.