The market outruns profits

I created a new model of the S&P500 that incorporates more variables and some nonlinear action. The chart at the left shows the results. The blue line represents the quarterly averages of the S&P 500 while the red shows quarterly averages produced by the model, the last three quarters of which are forecasts. The data analyzes quarterly averages because profit data is reported quarterly by the Bureau of Economic Analysis.

The model uses data back to 1948, and as the reader can see the value of the market has run ahead of where it should be in proportion to the growth in profits. Something similar happened in the dot.com bubble of 2000 but to a greater degree. Obviously, the market can deviate from valuations justified by profits for a very long time if people are confident, less risk averse, and willing to drive PE ratios higher.

The market could continue to rise through the holiday season if investors become convinced that the Fed will not raise interest rates due to poor economic data. And if the data become bad enough, investors might expect more rounds of quantitative easing in which the Fed pumps dollars into the economy by purchasing bonds from banks, or as I wrote last week, introduces the US to negative interest rates.

I don't expect profits to rise enough to justify the high valuations in the market since profits have been at record levels and are declining in the current reporting season. According the WSJ:

Profit and revenue are falling in tandem for the first time in six years, with a third of S&P 500 companies reporting so far. 

 Historically, profits continue to fall once they have climbed to record heights and start descending. The most likely scenario is that the market will fall to valuations more in line with falling profits.