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Stock Trends Send Signals To Investors

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The Tampa Tribune

Published: October 7, 2007

Corporate profits are in danger - even if we don't get a recession.

Investors are anxiously awaiting third-quarter earnings, worried that a slowing economy may have damaged company profits. But even if the economy keeps humming along, things could get rough for stock-market investors.

The problem: Corporate profits have been growing far faster than the economy. That can't go on forever - and that means you may want to tweak your strategy.

•Rising share. It's reasonable to expect share prices to climb as the economy grows. After all, an expanding economy should drive up corporate profits, and that, in turn, ought to propel share prices higher.

But in fact, over the past 25 years, the economy has grown an average of 5.9 percent a year - and the shares in the Standard & Poor's 500 index have soared an annual 10.3 percent. Tack on dividends, and you get an annual total return for the S&P 500 of 13.4 percent, according to Morningstar's Ibbotson Associates.

Why have stock prices handily outpaced economic growth? Maybe the most commonly cited reason is the stock market's rising price-earnings multiple. Today, the S&P 500 is at 18 times reported earnings, versus less than eight times earnings in early 1982. One worry: This rise in P-Es could go into reverse, handing big losses to stock-market investors.

There is, however, another reason for the stock market's dazzling performance - one that might seem more comforting. Although corporate profits were sluggish in the 1980s, they have skyrocketed since then, climbing 8.2 percent a year since 1990.

Impressed? The problem is, corporate profits have raced ahead of the economy, which grew just 5.3 percent a year over that stretch.

Result: In 2006, corporate profits claimed 13.3 percent of national income, versus 8.6 percent in 1990 and just 7.3 percent in 1982. These figures were calculated by Washington's Center on Budget and Policy Priorities using Commerce Department data. The last time corporate profits claimed such a large share of the economy's rewards was in 1965.

•Falling behind. This trend, with profits taking an ever-larger share of the economy, 'can't go on forever,' notes New York economic consultant Peter Bernstein, author of 'Capital Ideas Evolving.'

'It's impossible for that to be sustained because, if it was, all income would be profits.'

Bernstein notes that the S&P 500 companies now get 40 percent of their earnings from abroad, and he speculates that the corporate-profit bonanza has been partly driven by foreign growth. But it's pretty clear the surge in earnings also has come at the expense of employees.

While corporate profits have been snagging a larger share of national income, the portion going to wages and salaries has shrunk, declining from 56.5 percent in 1980 to 51.7 percent in 2006. Perhaps that's the reason the economy has been booming - but many Americans feel today like they're falling behind.

•Playing defense. This doesn't mean we're in for some sort of market calamity. Just as the S&P 500 is unlikely to retreat to eight times earnings, so corporate profits probably won't fall back to 1982's 7.3 percent of national income.

It's hard to know how all this will play out, and your portfolio should reflect the uncertainty. Allocate 25 percent or 30 percent of your stock-market money to foreign shares. Consider stashing a little more than usual in bonds and cash investments.

Also, keep both investment costs and your portfolio's tax bill low by making the most of retirement accounts and favoring low-expense index funds. That way, you will keep more of whatever the market delivers.

Maybe most important, rein in your expectations. And boost your savings rate to 12 percent or even 15 percent of pretax income.

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