Corporate Profits, the mother's milk of stocks and the economy have weakened dramatically over the past 6 quarters.  Energy firms, Apple, and the ending of many corporate tax credits have all caused a deterioration of overall corporate profitability.  Without profits firms are unable to increase investment and expand hiring and if credit conditions deteriorate as well then corporations start to shed employees and cut back dramatically on investment.  Over the past 10 quarters, overall after tax domestic profits have dropped by over 20%.  As a percentage of nominal GDP the drop is more dramatic with a drop of almost 27% - dropping from 7.57% in Q2 2013 to 5.53% at the end of 2015.

S&P 500 Earnings per Share (EPS) tend to lag the overall profitability of the economy by 3-4 quarters.  The relationship is pretty good over time - making a large profit rebound in 2016 in S&P 500 EPS unlikely.  In the chart below, S&P 500 EPS are in red and clearly following the drop in overall domestic profits.

The situation is not yet dire, but one might characterize the profit situation as a "Yellow" caution light for this economic expansion.  Further deterioration coupled with tighter credit conditions would be a harbinger of an overall economic recession.

Kevin Spires, CFA, FRM

Kevin Spires, CFA, FRM

Included in the 2nd Quarter GDP update this morning was the first look at economy wide corporate profits.  In my mind, the first shot across the bow presaging the next recession has been fired.

Domestic Corporate Profits, as reported by the Bureau of Economic Analysis, are highly correlated to the S&P 500's Earning Per Share (EPS). 

Q2 Corporate Profits, after tax, were down slightly from the first quarter, and are down 10.9% from their peak in the 4th quarter of 2011.  Much of the swing is due to the expiration of accelerated depreciation allowances - which were lowering profits and taxes, but even accounting for those adjustments, overall profits look like they have peaked.

If Corporate profits have peaked, look for them to mean revert over time and fall back to their long term average - which would imply a fall of 25% from current levels.  Peaks in Corporate Profits have a good record of leading peaks in GDP growth over the past 40 years - usually by at least 6-8 quarters.

I have been dismissive of calls for a double dip recession based in part on the strength in Corporate Profits.  A sustained drop in profits would be the first real shot across the bow of this recovery.  All the noise of Europe, flash crashes, Debt Ceiling Debacles, and the Japan Earthquake/Meltdown supply shocks were meaningless in the face of low interest rates and growing corporate profits.   With the peak in Corporate Profits, one of the preconditions of a recession is now in place -

Kevin Spires, CFA, FRM

With the update to first quarter GDP, the BEA released their first picture of Corporate Profits for the first quarter.  I like to look at after tax corporate profits as a percentage of Nominal GDP.  On this basis, Corporate Profits dropped to 7.2% from 7.6% in the 1st quarter of 2012 from the 4th quarter of 2011.

As Larry Kudlow likes to say Corporate Profits are "the Mother's Milk of stocks, business success and job creation."  Corporate Profits reported in the GDP Report tend to lead reported corporate profits of companies in the S&P 500 by 2 quarters.  With the potential peak in Corporate Profits for the GDP report, S&P 500 earnings may be about to peak as well. 

Trouble could be brewing.  The stock market tends to peak after the peak in corporate profits.  The timing is uncertain as the stock market peak follows with an uncertain lag.  It took three years from the 1997 peak in profits to the 2000 peak in stocks while it only took one year from the 2006 peak in profits to the 2007 peak in the stock market. 

Once Stocks peak, given a peak in corporate profits, then a recession is usually just around the corner.  If the peak in Corporate Profits is confirmed over the next two quarters, the Stock Market - and the whole economy - will enter a much more fragile stage of the economic cycle.

I am skeptical that the current expansion is about to fall apart of its own accord, but the dual uncertainty of tax increases on the table for the end of 2012 and the pending implemenation of Obamacare have caused a certain amount of investment and hiring to be pushed back by Corporate America.  A potentially strong expansion based on Corporate Profitability has been turned into the weakest recovery outside of the Great Depression. The upcoming U.S. Elections will be crucial for relieving economic uncertainty and I expect many months of choppy performance in the markets as uncertainty reigns. 

Click here for our Corporate Profits Chart Package.