Record corporate profits are this stock market’s feet of clay. And it’s just a matter of time until they crumble. Although the rise in stock prices most recently has come largely from stocks simply becoming more expensive, as discussed in part one of “This isn’t Going to End Well” rising corporate earnings are also playing a critical role. Counter intuitively, there are two key reasons record profits are actually bad for future stock market prices. First, profits are mean reverting. History, teaches that record high profits, eventually fall and revert to their arithmetic mean over time–an action that takes stock prices lower in the process. Second, rather than strong economic growth and innovations around productivity driving profitability higher, profit growth has been increasingly generated by wage suppression and financial engineering.
Unwilling to yet call a bear market, I have nevertheless become increasingly negative on this bull market. But despite a rough January, the stock market, as measured by the S&P 500, remains above its 125-day moving average—a level it has held for over a year. As such it would still be premature to call the current bull market over. But it’s not too early to examine why a meaningful move down with a breach of important technical levels, such as the 125-day, will be a reason to adopt a defensive posture, rather than “buy the dip” as so many are already advocating. In the spirit of my first “A Scary Looking Market” post I’ve included some new charts that argue against many of the currently popular bullish arguments. There is good reason to believe that optimism for the ability of the Federal Reserve through monetary policy to engineer strong economic growth is misplaced. Also unlikely to be realized is the hope that stock price multiples will grow further in a Great Rotation of investors moving from cash and bonds into stocks.