Today the government released third quarter data on after-tax corporate profits. Profits fell, but only modestly relative to the second quarter, and profits were down only 7.8% over the preceding 12 months. Profits were 7.8% of GDP, way above their mean-reverting average of just over 6%. This chart takes the NIPA profits (which are distinct from GAAP profits, in that NIPA profits are based on actual tax filings by companies and are adjusted for inventory valuation and capital consumption allowances—thus making them similar to economic profits, whereas GAAP profits are accounting profits and can be quite different) and uses them as a proxy for corporate earnings. It divides those earnings by the yield on 10-year Treasuries to get the capitalized value of all U.S. corporations (blue line). It then uses the S&P 500 index as a proxy for the price of all corporations (red line). The model is similar in construction to the "Fed Model" of equity valuations, and is my version of a similar model that Art Laffer has used profitably for decades.
What jumps out at you is the unprecedented degree to which stocks are undervalued today. The gap between these two lines has never been so huge. It's enough to make you question whether the model makes any sense at all, or whether there is something horribly wrong with the data. Or whether the stock market is just simply in the grips of a massive deleveraging panic that has driven valuations to absurd levels. Or maybe the 10-year Treasury yield is so artificially low due to panic conditions that it is inflating capitalized profits? To test whether the latter explanation is reasonable, it would take a 10-year Treasury yield of 10.4% to make the model say that stocks were fairly valued today. That's a big stretch.
I'll stick with the conclusion that stocks are incredibly undervalued today for a variety of reasons, but even the sum of those reasons fails to fully explain what is going on. The financial market is still in the grips of panic, deleveraging selling; liquidity in the bond market is dismal; the ability of anyone to reliably quantify the risk of subprime-backed, asset-backed, and commercial real estate-backed securities is highly questionable; our government is in a state of flux; the threat of higher taxes on capital is real; the threat of protectionist policies is real. But even if Obama makes a series of blunders, one big thing distinguishes the current period from the Depression, and that is monetary policy. The Fed today is simply not going to allow the monetary contraction that crippled the economy in the 1930s. And although I dislike Obama because of his socialist instincts, I seriously doubt he is going to blindly make every mistake in the books.
So I'm left with the conclusion that stocks are cheap.