Friday, March 26, 2010

Equities remain very cheap based on corporate profits



With today's final revision to fourth quarter GDP we also received information on corporate profits, and they were strong. The top chart compares the true economic profits of all U.S. corporations (after tax, and with adjustments for inventory valuation and capital consumption) to nominal GDP. Note that profits doubled from 1998 to 2009, yet the S&P 500 index today is still lower than it was at the end of 1998. The second chart shows profits as a percent of GDP; note that profits by this measure have almost recovered all the losses that occurred in late 2008. By any standard, the corporate profits picture is very bright.


The third chart is my variation on Art Laffer's equity valuation model, which in turn is a variation on the "Fed Model" of corporate valuation. It uses the after-tax corporate profits measure from the top chart and capitalizes it using the 10-year Treasury yield, and compares that to the market's actual capitalization using a normalized S&P 500 index as a proxy. By this measure, equities continue to be extremely undervalued. Another way of looking at this is that the market is discounting current profits using an 8% 10-yr Treasury yield, or a 50% drop in corporate profits from here. Simply put, according to this model the market is priced to some very awful assumptions.


The last chart simply extends the time horizon of the third chart, to encompass all the available data on this measure of corporate profits. If nothing else, it shows that capitalized profits and market cap track each other quite closely over a very long period. The model revealed that the market was significantly overpriced in 2000, and it has been pointing to a gigantic undervaluation of the market since late 2008. I would expect the current undervaluation to shrink by way of rising Treasury yields and rising equity prices. Leaving profits constant, the red and blue line in this last chart could close their gap with, for example, 10-yr yields at 5.5% and the S&P 500 up 50% from current levels. Both sound reasonable to me.

19 comments:

Public Library said...

Are 8% 10YR yields really that out of the question in the next few years? Just saying....

Public Library said...

You obviously have a ton of faith in Bernanke et al...

brodero said...

Amen Scott....also net cash flow to GDP is at an alltime high of 11.36%...with corporate profits after tax currently at a low 67% of
cash flow....we still have room for
profits to grow....

septizoniom said...

why are you right and the wisdom of the entire market wrong? have you examined why you might be wrong?

krispyhoochie said...

Hi Scott,
I was wondering if you can give me your opinion on the relationship between the price of oil and the refiners. The crack spread. I have been looking at investing in the refiners, they look very undervalued particularly valero and was wondering what your thoughts about the refiners in general, oil, crack spread etc.

By the way, I want to thank you for always giving me clear and consise advice. There is so much noise in the market it's nice to hear simple and to the point answers.

thanks

Steven

CDO Squared said...

Scott - - I really enjoy the blog. It is great, especially the charts and graphs!

Two points on this post - -
1) High level theory on what discounting rate should be used... it seems that using a Treasury rate is implicitly making a zero risk premium argument. Paul Kasriel uses the Moody's Aaa bond yield in his Kasriel Valuation model - essentially Art Laffer's model but with the discount rate change (March 28, 2003 in his archive http://www.northerntrust.com/library/econ_research/weekly/us/) Even then, seems like we would want to have some sort of risk premium on top of that, as that yield represents a senior claim.

2) John Hussman wrote a critical piece of the Fed model that may be of interest( http://hussmanfunds.com/wmc/wmc070820.htm ) Essentially arguing that it's apparent predictive power in the 1980 to 2000 period is a statistical coincidence and that it doesn't hold up over longer time periods:

"If you look at the relationship between earnings yields and Treasury yields, you'll notice that earnings yields and interest rates do not move tightly together. The notable exception is the period from about 1980 to 1998. During that period, you'll notice that the Treasury yield and the forward earnings yield moved lower together in an almost one-to-one fashion. It's that short but spurious one-to-one relationship that is the entire basis for the “Fed Model.” The model is simply a statistical artifact based on that period."


I think you have noted the NIPA profits are more stable than earnings typically used in the Fed Model.. a lot of Hussman's criticism typically stems from people using a single year of earnings which can be rather volatile rather than some sort of normalized measure.

Anyway, great blog.. love reading it.

Scott Grannis said...

septizoniom: dude, you need to chill. This is a model, not a pronouncement. It's a tool, a guide for gauging whether the market's valuation. I've been showing it for more than a year, and it's been sending a strong bullish signal, and it's been right. Could it be wrong now? Who knows. But it's a way of looking at the world that makes sense to me.

Scott Grannis said...

krispy: Sorry, but my expertise does not extend to refiners.

Scott Grannis said...

CDO: Using a corporate bond yield for a discount rate is sensible, but it wouldn't change the way the model works by much. I have supply-sider friends that prefer to use a corporate rate for a discount factor.

brodero said...

As of the 4th quarter of 2009 the S&P 500 was still trading below
NIPA Corporate profits after tax...
that is very cheap especially in a low inflation environment...

Scott Grannis said...

CDO: I'm aware of the criticisms of the model, but I still like it. It is one input among many that I rely on.

John said...

I appreciate this post because I have intuitively come to the same conclusion. If you look at the average pe ratios of blue chip US stocks around 2000 to 2001 they were very high relative to now. PEs today are much lower while prices are not much changed from eight or nine years ago. Companies have continued to grow their cash flows over the years but market participants have severly reduced what they have been willing to pay for those flows. The result is in my opinion significant undervaluation of US equities. One should keep in mind owners of common stocks own a STREAM of cash flow extending indefinately into the future. It seems like investors these days only pay attention to the past quarters earnings numbers.

Tom Burger said...

Scott,

Your model seems to have suggested significant undervaluation in 2007, also?

John: looking at PE ratios around 2000 and 2001 is not a particularly healthy comparison. We know now that 2000 was the peak of a particularly virulent bubble economy. Note, too, that for more than 10 years the stock market has delivered zero or negative returns since that time. Hussman thinks the whole bubble episode from 1993 on should be removed from one's valuation models.

According to Hussman's model the market is as expensive as any other market top, with the exception of 2000. Food for thought.

Hussman's model, incidentally, said the market was overvalued before the 2008 crash and undervalued at the bottom. You can read the history of his comments on the Hussman Funds web site. More food for thought.

Benjamin said...

Happy to see some optimism--but investors might be justifiably wary right now.

Our financial system just collapsed, after all--the very same system we have now. So, what is a company worth, if we suffer a second collapse?


Should investors be wary?

There are still heavily leveraged hedge funds operating, some on bank balance sheets. Is there another Long-Term Capital Management out there, a financial hunter-killer submarine ready to torpedo many years of steady productive work by others?

Look what LTCM did in 1997--many more such outfits out there now. Dozens and dozens, with kids at computers, leveraging up 100-to-1.

Greenspan and Volcker have recommended increased collateral on derivative trading, and boosted bank reserves.

Investors, and Main St. need to know that our bank system will not collapse again. There is no assurance of that now. Our system collapsed right after a period of solid R-Party domination of DC--the R-Party controlled the House, Senate, White House and Supreme Court. But our financial system collapsed If our financial collapsed under R-Party rule, can we have faith in it now?

But I hope for a rally too--and if we bulwark our financial system, and reduce deficits, I think we can have another secular bull market.

John said...

Tom,

I have read Hussman from time to time and he is a very bright guy. It is always a good thing to know what he is thinking. However if you look at the returns in his funds it appears he has been very skeptical of the recent recovery and it shows in his investment performance. Everyone invests for their respective risk tolerance and his has always seemed low to me. He does well in down markets but not so hot when the worm turns. To each his own.

No question valuations were high in 2000, 2001. Probably too high as you suggest. I merely pointed out that over the last ten years or so they have become considerably less so. Three nasty bear markets in ten years leaves an awful lot of investors gun shy. Maybe the pendelum has swung the other way long enough to open up some opportunities for those of us willing to accept a little volatility.

Good luck to you.

Gary said...

Scott -- the big issue with trying to value the market based on capitalized earnings discounted by the 10yr yield, is that you are assuming the 10yr yield is priced correctly.

Around 2000-2001 is when Greenspan and Bernanke started whining about deflation and openly manipulating bond prices. I still don't buy their argument about deflation, since the cost of living continues to climb.

But even if you accept their premise -- the point remains that starting around 2000 or 2001, the 10yr yield is no longer market priced. At best, it is a half market price, half central economic committee priced.

The model could be interpretted as stocks are cheap -- OR -- that 10yr bonds are over priced (ie yields are too low).

With yields too low, we are seeing inflation creep in, slowly at first but clearly accelerating. Stock prices are unchanged in real terms, but are climbing in nominal terms.

Historically, I would say the bond market is smarter than the stock market (speaking as an "unbiased" bond guy) -- but in this case the stock market figured it out first. The bond guys were busy claiming subprime was AAA.

Gary said...
This comment has been removed by the author.
DaleW said...

I don't agree with the "Fed model" either. The equity market has returned over time real growth + monetary inflation + an equity risk premium. You can also state that as the risk-free rate plus an equity risk premium. That also equals TIPS + breakeven rate plus an equity risk premium. We can further break down the ERP as the credit risk premium for corporates plus an equity risk premium. These last two break down to about 2.0% and 2.5% and they all add up to about 9% to 10% over very long periods of time. Therefore, I believe it is most appropriate to use corporate bonds plus an equity risk premium or treasuries plus a a credit risk premium plus an equity risk premium. As you have pointed out, the TIPS are implying low real growth and the breakeven rate is implying more inflation than real growth. That's not a great equation for equities, thus the larger than historical equity risk premium at present.

Finally, I think it makes more sense to use a very wide market index vs. NIPA profits because not all NIPA profits accrue to the S&P 500 (nor do they all accrue to any equity index because NIPA profits include profits of companies that are not publicly traded.

Scott Grannis said...

Thanks for the many comments and criticisms. This proves once again that valuation is an art, not a science, and that means that there will always be a way to "beat the market," but it won't be easy. It's a never-ending challenge and the playing field is always changing.