Corporate profits for US companies—especially small caps—could be set to soar 20% in the first half of 2015.

That’s what happens when the CPI—the Consumer Price Index—breaks up and away from the PPI—the Producer Price Index.

The chart below (courtesy of  Unit Economics in Boston) shows that the Consumer Price Index has only moved slightly negative (only 0.1%) in its most recent measurement:

But the move down in the Producer Price Index has been much larger at 3.1%:

Corporate profits are the difference between the revenue a company generates (related to CPI) and how much it has to spend to generate that revenue (related to PPI).  Watching the relationship between the CPI and PPI can provide direct insight into how corporate profits are tracking.

The CPI measures the retail prices of goods and services purchased by U.S. consumers.  These are the prices that consumers are paying—and therefore the prices that corporations are receiving.

The CPI tells us what is happening to the top lines (revenue) of corporations.  If it drops, revenue drops.

The PPI meanwhile measures the prices that producers of domestic goods and services are receiving.  These are the wholesale prices that corporations are paying and are therefore a good indication of how their input costs are trending.

The PPI tells us what is happening to the expense lines of corporations.  If it drops, expenses drop.

If the CPI stays flat and the PPI rises, corporate margins are going to be squeezed.  On the other hand if the CPI stays flat and the PPI drops corporate margins are going to expand. While the CPI has trended down marginally on the back of lower energy costs, the PPI has plunged.

The above two charts indicate the US should experience a rapid expansion in US corporate profits as companies SELL their products at CPI-linked prices, but have production costs linked to the Producer Price Index (PPI) – which is absolutely plunging.

With the market sour on corporate profitability–because of the high and rising US dollar–this creates the recipe for positive earnings surprises that will drive stock prices higher.

The chart below tracks how US corporate profits move with the CPI-PPI relationship.  The white line is the CPI minus the PPI (-.01 minus -3.1 = 3). Whenever the white line spikes up–like it is now and like it did in 2009–corporate profits (the yellow line) are quick to follow.

Source: Unit Economics, Boston MA

Unit Economics estimates that this 3% expansion in margins will translate to nearly a 20% increase in overall profit growth.  They believe that there will be roughly a two month lag between the numbers that show up in the CPI/PPI and the timing of U.S. corporate profit growth.   That should make for a good Q1 for US small caps (which will benefit in March) and a blow-out Q2.

This idea of a surge in corporate profits is against market consensus now, which is focused on weak international GDP growth and also the stronger US dollar.

That’s potentially true, but it misses the fact that not all companies face those challenges equally.  Large caps doing a lot of business internationally will face big headwinds in 2015 even with the CPI/PPI margin expansion.

On the other hand small caps that are focused only on US consumers avoid those headwinds AND have a strong tailwind from the margin expansion that the CPI/PPI trends have identified.

That should set the stage for significant outperformance for small cap US focused companies in 2015.

EDITORS NOTE: The two editors at our sister newsletter at www.SmallcapDiscoveries.com spend all their time doing bottom-up research on individual small and micro-cap companies with a US focus.  Paul Andreola and Brandon Mackie go through quarterly financials of publicly traded small caps every night as they are posted to SEDAR and EDGAR, the regulatory websites for pubco financials in Canada and the US.

They look for orphaned stocks with positive cash flow, partway into a big growth curve.  They search for the stocks that are going to go up 2, 3 or even 10 times over a period of 2-5 years.

They look in the corners of the market that are ignored by the big institutional investors.  When you combine their stock picking with the tailwind of the surging corporate profits that are coming in 2015 the results can become truly exceptional.

Paul and Brandon are issuing a new stock pick on Monday March 30 after market close at 4 pm Eastern Daylight Time.  The subscription page will re-open for only the next 7 days–until they release the 12 page report on this fast growing American micro-cap.  To join our exclusive small community–and our new Subscriber Chat Forum–CLICK HERE.