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Along with today's latest revision to Q1/10 GDP, we also received the initial estimate of corporate profits. In the year ending March '10, adjusted corporate profits after tax rose 24% from a year earlier. Compared to profits in 1998, when the S&P 500 was trading at approximately the same level as it is today, profits today are about twice as high. Looked at another way (second chart), profits as a % of GDP were about 6.5% of GDP in 1998, whereas today they are 7.7%, a level that rarely has been exceeded in the past 50+ years. Of course, many would argue that the market was entering bubble territory in 1998, but if even if that were indeed the case (though it was not obvious back then, as I recall), then surely equities are not overvalued today.
As the last chart shows, the recent strength in profits is by and large coming from nonfinancial domestic corporations, the meat-and-potatos sector of the economy, if you will.
I look at these facts and come away thinking that the corporate profits picture looks pretty darn impressive, especially considering how much the economy has been struggling in the past year or two. Equities are just not getting the respect that these numbers suggest they deserve. (Note that I am using the National Income and Products Accounts measure of profits, not the profits that are commonly used to calculate PE ratios. In my experience NIPA profits are much less volatile and more reliable, since they include all corporations and they are adjusted for inventory valuation and capital consumption allowances, so they are effectively equivalent to true economic profits. I owe a big HT to Art Laffer for this, since he has been following this series closely for as long as I can remember.)
8 comments:
Scott,
With so much of US corporate profits coming from international markets, I'm always skeptical about the comparison you make.... a little apples vs. oranges I think.
Regards,
Michael
PS- I love you blog... thanks so much for doing it.
Michael: I dont understand your concern, since my last chart shows that nonfinancial domestic corporate profits have been stronger than profits overall. I haven't seen the data but from this it would likely follow that nondomestic profits (foreign) have been generally weak.
Even with today's price action the S&P 500 is below the NIPA
corporate profits after tax. Over the last 60 years this condition has
occurred during 11 years. The average inflation rate for those 11 years
was 5.82% (one reason why the profits were not valued more). Today
we have the same condition with low inflation.
On another point the ratio to
after tax profits to cash flow is
still a lowish .67. As the recovery
proceeds this ratio will likely rise.
This is off subject and I apologize but the ratio of net cash flow to gross private domestic
investment has over the last 50 years averaged .55 and right before
the recession it was around .60. Today it is at .95 after hitting
a high of 1.01 in the 3rd qtr 2009.
An eventual reversion to the mean or even partially (say .75) implies
a stronger recovery than people are thinking about.
Scott, why do you think corporate profits as a percent of GDP have mostly been running above you mean line over the past couple of decades? How do we know they won't revert to the mean, if not lower, in the coming years?
Thanks, Mark
Scott,
You are right, the last chart does show "domestic profits". Knowing that corporations do not release information on profits by region I wondered where BEA got their numbers. I found on the BEA website a 36 page description of their process... and it is not based on profit information from US corporations, but instead is a very elaborate estimate of what domestic profits are, using BEA assumptions. OK, so do we believe these numbers? Maybe so, I cannot really judge.
Regards,
Michael
Mark: there's no way of knowing where profits will go in the future. But I will note that the direction of profits as a % of GDP tends to correlate with the performance of stocks. When profits trend higher relative to GDP stocks have typically done very well, and vice versa. My main point however is that this data suggests that the market is taking a very pessimistic view of things. The market is very worried, and is not overvalued.
Michael: The corporate profits data generated by BEA is adjusted, so you can't rely on it 100%. But it is based originally on information contained in corporate tax returns, so it's unlikely to overstate true profits. In any event, I think it's the best source of information on corporate profits that we have, and it has been produced in a consistent manner for over 50 years.
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