The latest forecast from my model of the S&P 500 index for the first quarter of 2015 indicates that the market continues to outrun corporate profits. The pattern is similar to that of the late 1990s. When the market turns, it will fall below the level that profits would indicate as investors become pessimistic and afraid. It's likely that any January effect this next quarter will be small as the market corrects for profits.
When the market gets ahead of the forecast it means that the P/E ratio is expanding because investors are willing to pay more for the same level of profits. Some of that optimism comes from chasing yields as more bond holders grow weary of earning about one percent in real terms on bonds. Other buying comes from speculation about what the Fed will do.
Below is a graph of the corporate retail profit rate calculated from the Bureau of Economic Affairs data. The profit rates will be higher than those reported by the Standard and Poors because the BEA data doesn't include most of the adjustments companies make to their data, but the data suffers less from executive manipulation, too. Think of these as something similar to operating profits.
The profit rate in retail hit a record high of 17.6% in Q2 of 2013 and has drifted downward since. Readers familiar with Hayek's Ricardo Effect will appreciate the importance of retail profits. According to Hayek, the turning point in the business cycle happens when profits in consumer goods industries persuade businessmen to use more labor (having employees work overtime, for example) and to put off buying new equipment.
High profits in retail indicate that the Ricardo Effect may be ready to kick in. Another indicator that supports the Ricardo Effect is the latest GDP report showing a real increase of 5% at an annual rate. GDP calculations are heavily weighted toward retail and consumer goods.
Also, the prices of most commodities are near cycle lows, which tells me that equipment makers are buying less raw materials because they are facing slack demand for their products. Low demand for raw materials will back up like a clogged sewer into the businesses producing mining equipment and hurt profits there. We have already seen that process at work in the oil industry where companies are slashing capital expenditures and cutting employment.
As businesses in capital equipment industries suffer and reduce employment, profits in all sectors, including retail, will fall, and when profits fall so does the stock market. No one can tell when the stock market will face its next crisis, but the accumulation of omens point to a turning point in 2015. I wouldn't be surprised if Q3 of this year turned out to be the turning point.