It is a constant source of conjecture whether the stock market is an effective lead indicator when it comes to the potential of the wider economy. One might suggest the market rally this year is validated by recent encouraging data on UK manufacturing, which is showing its first real expansion for some time, along with positive US house prices and jobs data. However, by another key measure, net profits, companies in the UK are still lagging behind the levels achieved in 2007 - and to a degree that brings the foundation of the market rally into question.
The perception that share prices around the world have little to do with economic performance is strengthened by the latest survey of profitability at FTSE 100 companies by analysts at broking company The Share Centre. Admittedly, although profit statistics aren't 'forward looking' as such, they showed a "remarkably weak" performance through 2012, with net profits plunging by 29.7 per cent to £114bn - only the crisis year of 2008 demonstrates a comparable fall. Part of the problem may be the concentration of the market, with just three industries generating 86 per cent of all sales.
Analysts put this down to a series of unusual events that dampened the profits of UK companies last year. The first of these is the high weighting of the FTSE 100 towards extractive industries, particularly mining. This has long been cited as a weakness of the index. Resource companies are 'price takers', which makes them vulnerable to commodity price volatility. Prices surged throughout most of the past decade, but have since stagnated at a time when operating costs are still high. In this scenario, capital spending is cut to boost the bottom line; in spite of remedial action miners' profits slumped by £25.6bn to just £7.9bn in 2012. Finance is also a big contributor to UK profits but increasing regulation and a legacy of bad loans is holding the sector back. By contrast, profits for defensive companies in consumer goods and pharmaceuticals were only 2.5 per cent lower, which may help explain why defensives have been particularly strong during the first half of this year.
