Whether we are taking a view of an individual company or a whole market, the outlook for profits growth is one of the most important inputs into the investment decision. While stock prices can rise if profits fall, and vice versa, it doesn't happen very often or for very long, writes Chris Johns

If we can make some informed guesses about the direction of profits, we will generally not go too far wrong with our guesses about stock prices. Moreover, if we can determine the likely mistakes made by others, we will gain extremely valuable insights into likely market behaviour.

Right now, the big call is whether or not US profits will grow next year.

Equity prices always embody some expectation about future growth. The most obvious way of measuring this expectation is simply to look at the average of all analysts' forecasts.

For most major markets, such data is readily available and it is easy to see what individual analysts are forecasting for a company, or what is expected for the market as a whole.

Last week I dealt with some of the issues surrounding the definition and measurement of earnings. One way of side-stepping (up to a point, at least) those issues is to look at what the analysts are forecasting and decide whether or not you think they are being too optimistic or pessimistic - earnings "surprises" are key drivers of share price performance.

Such an approach is particularly appropriate at the moment, as forward-looking markets begin to think about the outlook for 2005.

The US is, as always, the best place to start - this is where we have the most detailed information and this is the market (and economy) to which most of the world's stock markets are linked.

Few people will be surprised to learn that forecasters are optimistic about US profits growth next year, with a consensus expectation of an 11 per cent expansion in earnings from the fourth quarter of this year to the same period in 2005.

Such optimism is based on a number of key assumptions, two of which merit close examination.

Firstly, there is an explicit forecast of significant "top-line" growth; the best overall proxy for this is gross domestic product (GDP) growth, which is expected to come in at around 3-4 per cent in real terms.

Secondly, the benefits of this growth are expected to flow mostly to profits rather than wages - this assumption embodies a continuation of the US productivity miracle.

Doubts about these growth forecasts arise because of the imbalanced nature of the US recovery to date. Prominent forecasters, such as Mr Steven Roach of Morgan Stanley, argue that households simply cannot run down their savings any more (because the saving rate is now close to zero) and the parlous state of government finances leave no room for further tax cuts.

Increased debt and lower taxes have driven strong economic growth so far, but their scope to do so in the future is heavily circumscribed. Moreover, any growth that does come through is now less likely to feed through into the bottom line; wage costs will rise now that the labour market is staging a recovery (of sorts).

A growth slowdown combined with a tighter labour market could be a lethal combination for profits growth.

Profits as a percentage of total GDP are close to a record high: if the profit share is due for a cyclical tumble, as the pessimists believe, then all those bullish forecasts could prove to be very silly indeed.

These sorts of concerns could have been voiced at any time during the past four or five years. Indeed, Mr Roach has stuck to his mega-bearish line for as long as most people can remember; he has been right once or twice but, in my view, mostly wrong. The US consumer has continued to consume.

But with the US economy looking as if it has hit a soft patch already, doubts about those profits forecasts will only grow if, like the proverbial stopped clock, Mr Roach's turn to be correct comes round again.

In the quarter to the end of June, US operating profits grew by around 30 per cent compared to a year ago. Companies reported a near 7 per cent gain in earnings compared to the previous quarter, which itself was a bumper period. But a close examination of these numbers also reveals a slowing in momentum. And, sadly, we have to remind ourselves that these are the numbers that companies report to the market: all of those measurement issues are still there, lurking in the background.

One piece of evidence that suggests that profits momentum may be slowing by even more than firms are owning up to is contained in a different data source, the national accounts. The profits numbers reported here are taken from the tax filings of companies and, hence, are thought less likely to be exaggerated than the numbers spoon-fed to analysts and investors. And in the quarter to the end of June, profits on this definition actually fell - not by much but a fall nonetheless.

The fact that the consensus forecast for US profits in 2005 is likely to be too optimistic will not come as a shock to markets. Investors have grown used to the ingrained bullishness of the average analyst. But so long as modest earnings growth continues, markets will retain their poise (but are unlikely to get too excited).

The big shock will be if the doomsters are right and profits actually fall - in which case, the US stock market will probably fall as well, with all sorts of negative implications for European equities.

My own view is that the pessimists will be proved wrong, yet again, but it has to be acknowledged that the recent flow of data is going their way. If the doom-mongers are right, the correct decision is to exit equities now and for portfolios to contain a lot of cash and bonds.

Individual investors need to make their minds up about the sign on US profits growth for next year: positive or negative? Investors should ask their brokers or fund managers what they think about this fundamentally important question.