Looking Under the Hood

The bull versus bear debate continues to rage on and off Wall Street, with the bears prominently pointing to faltering housing and auto industries and to an inverted Treasury yield curve that, according to one widely watched Federal Reserve model, estimates over a 50% chance of a recession in coming quarters. Clearly, there are enough negative indicators at work for the bear case to merit close attention, and we have been carefully analyzing how various indicators are lining up in the current business cycle compared to prior ones.

One of our more interesting findings argues against the bear case, and by extension, against the bet that a Fed rate cut is in the immediate offing. Using the most recent Corporate Profits After Tax (CPATAX) data released by the Commerce Department’s Bureau of Economic Analysis, we compared the trajectory of corporate profits over the current period (2001-2006) and most recent period (1996-2001) to contrast the underlying business performance in each. We distinguish between these periods on the basis of U.S. monetary policy: from 1996 to 2001, the federal government pursued an explicit “strong dollar” policy, the Federal Reserve publicly fretted about “irrational exuberance” in asset prices, and USD money and credit conditions were tight globally; the 2001-2006 period began with the Federal Reserve gnashing its teeth over the threat of deflation and lowering its overnight target rate to historic lows, and since that time the U.S. dollar has lost significant value against other currencies, industrial and other commodity prices have reached historic levels, and core inflation has been printing slowly but steadily higher.

When comparing corporate profits between these two periods, we find that they differ starkly — year-to-year growth in profits from 1996 to 2001 averaged only ten basis points, while from 2001 to 2006, it has averaged just under 15%. Importantly, the preliminary estimates for 3Q06 CPATAX do not show any sign of rolling over, increasing 4.5% sequentially and 31% year over year:

Despite the current soft patch, we continue to stand by our assessment that the domestic and global economies are still performing well, and that capital markets should remain relatively healthy as long as no significant new externalities come into play in the coming year. With that in mind, and given that price level stability is (or at least should be) the primary aim of monetary policy, we’re standing by our expectation that the Fed will hold its position until enough indicators point to a levelling off of inflation somewhere around its unofficial comfort zone of 2%. Should inflation surprise to the upside, we may even see additional tightening in 2007, which could cause a significant spike in volatility as markets are forced to reassess their expectations, as happened in June of 2006: