What Do Corporate Profits Tell Us About the Business Cycle?

Perhaps the number one question that investors ask us—and with good reason—is: When will the U.S. economy enter recession? (Though bitcoin questions are gaining ground.) Having at least an educated guess as to when the next recession might occur can save investors a lot of money—in theory. Bear markets associated with recessions have produced an average loss of nearly 40% for the S&P 500 Index (covering recessions back to 1968).

As tough as it is to reliably predict recessions, we see value in analyzing various economic and market data points to determine what stage of the economic cycle we are in. One such indicator is the Leading Economic Index. We also look at a number of economic indicators, such as job growth, wages, inflation, and leverage; financial market indicators including the fed funds rate, credit spreads, the yield curve, and stock valuations; and, measures of consumer, business, and investor sentiment. Some of these measures are part of our recession watch dashboard.

Given that earnings are the biggest driver of stock prices over time, it makes sense to assess what corporate profits might be telling us about the potential length of the current cycle. (For you baseball fans, the question is: What inning are we in?) To do that, we identified peaks in S&P 500 earnings growth over the past 60 years and calculated the number of months from those peaks until the start of the next economic recession. As shown in the table, the average time period is about 49 months or just over four years (the median is 44 months).

The next logical question is: Have earnings peaked, and if so, when? September 2010 gave us a false signal in the form of an earnings growth peak and no subsequent economic recession—although an earnings recession arrived about five years later. Fast forward to today and the next peak is still forming; on a four quarter trailing basis, earnings accelerated through the third quarter of 2017. Could that mean the next recession may still be four years away? Possibly, though as the table shows, in several instances the profit peak was followed by an economic recession only a year or two later, as in 1990 and 2001. Regardless, this indicator suggests the economic cycle may still have room to run.

Also keep in mind, earnings growth may accelerate if corporate tax rates are reduced, and the runway potentially gets even longer, although that may not come until 2019 based on the latest reports out of Washington, D.C.

Risks are always there—policy risks, central bank risks, geopolitical risks, etc. But at this point, based on earnings and the other economic and market indicators we follow, the economic expansion may continue through 2018 and beyond.  Take a look at our Outlook 2018: Return of the Business Cycle publication, and our YouTube video, for our views on the economy and corporate earnings next year.

IMPORTANT DISCLOSURES

Past performance is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.

The economic forecasts set forth in the presentation may not develop as predicted.

This research material has been prepared by LPL Financial LLC.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Securities and Advisory services offered through LPL Financial LLC, a Registered Investment Advisor Member FINRA/SIPC

Tracking #1-678417 (Exp. 12/18)