Profits of Doom

Ah, another day in Paradise. LIBOR spreads blow out again, mercantilist central banks ramp EUR/USD higher, and oil prints (yawn) another new all-time high. Pity the poor chaps at Deutsche Bank; these markets aren't getting any easier, and now they can't even treat their customers to an expensive lunch or a "show" after work.

At the risk of flogging a dead horse, Macro Man continues to be intrigued by the dichotomy of opinion on US corporate profits. Over the last week or so, he has received fairly bearish research from Goldman, Morgan Stanley, and JP Morgan. Yet other shops, such as UBS and Lehman, appear to be more sanguine about the outlook for US corporate profits. The low volumes that have accompanied the recent slew of earnings announcements suggest that the market has yet to see enough to make up its mind one way or the other.

Why is it important? The trajectory of corporate profits can help to determine or confirm the trend in a number of macroeconomic and market variables. In 2006-07, for example, Macro Man was fairly confident of a US "muddle through" scenario because of the strength of corporate profits, particularly when expressed as a percentage of GDP. However, recent data points suggest that we've finally reached the top of the cyclical, and perhaps secular profits cycle; a reversion to the mean (in terms of profits/GDP) would appear to suggest either a profitless recovery or declining profits in a recession.
One of the indicators that Macro Man likes to keep an eye on is a quick and dirty proxy for corporate margins, the annual change in producer prices less the change in consumer prices. To be sure, this is not a perfect proxy, as high energy input prices can actually represent quite a fillip for the profits of the energy sector, which has obviously been one of the leading lights of the mid-Noughties rally.

But still, the signs from the indicator are very ominous indeed; the prior three descents into "negative margins" all preceded/accompanied recessions; however, for most of the past several years, this indicator has been in record negative territory. Now some of the "profits anomaly" of consistent profitability (through the middle of last year) despite apparently negative margins may well be down to the energy effect, as XOM, et al rake it in. But can that explain all of the S&P's pre-3Q07 profitability? Perhaps not. Perhaps what we're really seeing here is the impact of "something-for-nothing" type structures like CPDOs, SIVs, et al, which have latterly proven themselves to be more expensive than advertised. Insofar as those avenues are likely to remain closed for the foreseeable future, perhaps profits will re-anchor with the apparently unfavourable margin environment.
And finally, to talk his own book, Macro Man presents once again the evidence that multinationals (typically large cap) are a preferable hold to smalls caps, which have a more domestic focus. Through Q4, the NIPA profits that were derived domestically unsurprisingly fell y/y, whereas foreign profits have been gangbusters. And what have we seen so far this earnings season? International earnings have been pretty darned strong from the likes of IBM, Google, Intel, and even GE.
Macro Man cannot help but think that the party's just getting started for the large cap/small cap thesis.