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Good News on US Profits

Click here to buy - A How To Book of SMSF's by Tony Negline
John Robertson

US profits were up again in the June quarter suggesting that the worst in business conditions might have passed, validating the second quarter equity market strength and suggesting higher values to come.

We can say that the fair value of the current market should be a function of:

The starting point profit gives us a foundation on which to build a view about the future direction of equity values.

This is an analytical framework I use in a medium term model to forecast the direction of U.S. equity markets. The model has a definite medium term orientation. It has only indicated six turning points in 30 years. It said buy in 1979, sell in 1986, sell in 1989, buy in 1996, sell in 2000 and buy in 2006. It did not suggest that the market was overvalued at the end of 2007.

According to the data released last week by the official U.S. statistician, after tax corporate profits rose 7.6% in the latest June quarter after having gained 16.6% in the March quarter. Based on this, the cyclical low point in profits appears to have occurred in the December quarter.

Corporate profits still have some way to go to fully recover. They were 17.7% lower than in the previous corresponding period a year earlier and 23.3% lower than peak profits in September 2006.

While the most recent cyclical decline in profits is now associated with the global financial crisis, the beginning of the decline is actually three years old, predating by at least a year the lapse of the U.S. economy into a late 2007 recession.

If we take a step back to look at the medium term pace of growth, the impact of the global credit crisis has been less severe than one might imagine. Annual profit growth rates since mid 2002 have been 9.7%. Their resilience largely reflects the extraordinarily strong rate of growth achieved in 2004 when, over the year to June, profit growth hit 46.7%. It had gotten that high previously only in 1987 and, prior to that, in 1959. In other words, such strong profit growth has been historically unusual.

As many strategists had observed as the market was moving higher through 2005-07, the gains were reflecting some significant improvements in business financial outcomes. Importantly, the equity market never assumed a continuation of peak growth rates. Equity market conditions were not at the leading edge of the bubble economy in the most recent cycle.

By normal cyclical standards, therefore, the profit decline has apparently been modest and there has been only a limited need to change the long-term growth rates built into market expectations. At the same time, long-term interest rates have moved lower helping to boost the capitalized value of current profits.

When we pull together the most recent U.S. data, my modeling suggests that the U.S. market remains undervalued. However, by this measure, the market is less undervalued than it was in the first half of 2006. Under similar circumstances in past cycles, the market has continued to rise. Based on the historical relationships, there might be another 200 point upside in the S&P 500 index over a 12-18 month time horizon.

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