Daily Gains Letter

Profit Play on the Great Disappearing “Corporate Earnings Growth” Act

By Sasha Cekerevac for Daily Gains Letter |

Corporate ProfitsAs many of you already know, the gross domestic product (GDP) estimate for the third quarter came in above estimates at 3.6%, with most of the increase coming from higher inventory levels.

But I would like to look at something slightly different than the inventory buildup. I think we are all aware of what happens when inventory builds and consumers don’t buy—corporate profits get hit. However, looking at the data a bit closer, there are more worrisome signs aside from excess inventory that are also pointing to tough times ahead for corporate profits.

The S&P 500 has had a stellar run since its bottom in 2009. Part of the reason for this is that corporate profits have expanded tremendously as firms cut costs through massive layoffs, as well as lower financing payments through the cheap money provided by depressed interest rates. But this might be coming to a close, as corporate profits for S&P 500 companies appear to be peaking.

According to the latest data from the U.S. Department of Commerce, third-quarter corporate profits on an after-tax basis were a record 11.1% as a share of GDP. (Source: “National Income and Product Account, GDP 3rd Quarter 2013,” U.S. Department of Commerce, December 5, 2013.)

What this means is that the S&P 500 companies are generating extremely high profit margins. Obviously, this alone is not bad; however, business is always cyclical. We will always move from peaks to troughs, and corporate profits and margins are no exception.

Wall Street analysts continue to tell people that the S&P 500 is a buy, because they are taking the data from the past couple of years showing growth in corporate profits and extrapolating it out over the next couple of years.

The problem is that the way firms have generated growth in corporate profits is eroding. Over the past year, companies are actually beginning to hire new workers, albeit at a relatively slow pace. The net result is higher costs. Interest rates are beginning to move upward, too; again, this is a higher cost.

Revenues are not accelerating for S&P 500 companies. Most of the growth in corporate profits came from cost-cutting, not revenue growth.

Many analysts continue to believe corporate profits will grow 10%–15% next year, but if revenues are not increasing and costs are beginning to rise, this simply doesn’t add up.

Even the growth in corporate profits for S&P 500 companies is beginning to decelerate. Domestically, corporate profits generated by non-financial companies in the third quarter increased to $13.0 billion, a much lower level than the $37.8 billion of corporate profits generated in the second quarter.

I think we are already witnessing a deceleration in corporate profits, and many investors and analysts are far too optimistic in their belief that the S&P 500 companies can continue driving growth to the bottom line.

S&P 500Large Cap Index Chart

Chart courtesy of www.StockCharts.com

As the S&P 500 has recently continued moving higher, another worry for me is a negative divergence between the index and the moving average convergence/divergence (MACD) indicator. Essentially, the momentum appears to be decreasing, even as the S&P 500 moves higher. This doesn’t necessarily mean that the S&P 500 has made a top, but it is yet another worrisome sign for investors at these lofty levels.

For those investors who believe that the S&P 500 might pull back and want to profit over the short term, I would look to such inverse exchange-traded funds (ETF) as the ProShares Ultra Short S&P500 (NYSEArca/SDS), which moves up as the S&P 500 moves down.

This particular ETF seeks for an inverse of two times the return of the S&P 500 on a daily basis. Over the long term, leveraged ETFs will not mimic their specific indices in such a manner, but as short-term hedges, they might be suitable, depending on each investor’s risk profile.

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