Tuesday, August 4, 2009

Equity valuation (2)

This is an update from a post of early last April. Last week the government released some important revisions to the GDP and corporate profits data in the National Income and Products Accounts (NIPA). The new numbers show a steeper decline in the economy last year, as well as a much steeper decline in corporate profits.

Note that despite the recession and the obvious pain suffered by the corporate sector, profits are still above average today (they have averaged 6% of GDP since 1959, and I estimate they are about 6.4% today). In addition, note that profits today are about 60% higher than they were in early 1998, which was when the S&P 500 index first rose above 1000, as it has again this week. The 10-year Treasury yield (which the second chart uses to calculate capitalized profits) was 5.6% back then, whereas it is only 3.7% today. This explains why capitalized profits have risen almost 150% since 1998, but it doesn't explain why equity prices have not risen at all.

For more on the model I use to measure equity valuation, see here, here, and here.

The message of these two charts is that equity prices have not kept up with profits or capitalized profits, and not by a long shot. Equity prices are up about 50% from their March lows, but equities are still very, very cheap when compared to corporate profits and the level of interest rates. Technical indicators may call the current market "overbought," but this model suggests that equities are still suffering from a severely "oversold" condition when one considers the valuation fundamentals.

The gap between theoretical and actual valuation, according to this model, says that equities today are worth about half of what they should be worth. To close this gap, interest rates could rise to 7.75%, or corporate after-tax profits could decline by over 50%, or equity prices could double. Or we could see some combination of much higher interest rates and lower after-tax profits. As you see, the market is still pricing in some very nasty assumptions.

Full disclosure: I am fully invested, holding long positions in numerous equities, equity mutual funds, and equity index funds at the time of this writing.


Jake said...

by simple math, shouldn't profits grow slower than GDP? if not, then in the long run corporate profits > then GDP, which is an impossibility.

狂猪 said...

Can you share your thoughts on the P/E10 valuation method in comparison to yours? This is P/E using 10 year avg of real earning.


According to this, equity was over valued in 1998 and about fair value right now.


Scott Grannis said...

Jake: Over many years, corporate profits should tend to grow about the same as nominal GDP. And in fact they have, averaging 6% of GDP since 1959. Sometimes they grow faster, sometimes slower. It's a classical mean-reverting process.

Scott Grannis said...

Some thoughts on the P/E10 method: I'm uncomfortable with it because it gives much more weight to historical profits than to current profits. My method uses the most recent quarter's profits. Also, the P/E10 method uses profits as defined by GAAP, whereas my method uses economic profits as defined by the NIPA folks. GAAP profits tend to be more volatile than NIPA profits.

In any event, all valuation models have their shortcomings, so you have to take them with a few grains of salt, as we say.