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Although it has attracted little attention, US national accounts show that profits after tax fell in both Q4 2006 and Q1 2007, says Andrew Smithers of Smithers & Co, in his latest client report. The cause of the profit decline was, as usual in the short-term, a narrowing of profit margins.

Profit margins are most likely to fall in the short-term when they are very high and have recently fallen. The US currently satisfies both these conditions, notes Smithers.

To some extent, profit margins of non-financial companies rise and fall with capacity utilisation, which in turn depends on whether growth is above or below trend, he says. Although the connection is not very strong, profit margins may improve if US growth in Q2 2007 proves to have been above trend. But even then, says Smithers, this can only be a temporary phenomenon, as there is little spare capacity in the economy - and “such a favourable outcome is far from certain”.

Profits based on NIPA (National Income and Product Accounts) measures have in the past been a leading indicator of S&P 500 EPS, he says. The fall in the former over the past two quarters therefore increases the probability that the profits of listed companies will shortly start to fall, and a fall in NIPA profits for Q2 2007 will increase the likelihood that S&P 500 profits will fall in 2008.

Falls in EPS are not, however, strongly linked to stock market weakness over the next 12 months, says Smithers. “This is not only true in general, but is even true when falls exceed 10 per cent year on year”.

But falls in excess of 10 per cent have been significant when the cyclically adjusted PE (CAPE) is more than 25 per cent above its average; it is now more than 50 per cent higher, he notes.

Significant declines in US corporate profits are likely over the next one or two years, and the “significant overvaluation” of the US market makes it vulnerable. But there’s no need to hit the panic button now, as it seems unlikely, says Smithers, that listed companies’ profits will fall in the short-term by more than 10 per cent on a year on year basis.

Investors, therefore, can probably afford to consider “at least the next quarter’s NIPA profits data before becoming concerned about the impact of poor profits on the stock market”, he says. After all, the market depends on continued corporate buying and thus on credit spreads remaining tight and borrowing conditions easy.

“Despite some recent worries, this still seems to be the case”.

That’s comforting.