Monday, October 4, 2010
With the end of the third quarter behind us, it's time to update what we know or can infer about corporate profits and stock market valuations.
The top chart compares trailing, after-tax, 12-month profits (earnings per share) as reported by the S&P 500 (blue line) for September, with the annualized (Q2/10) after-tax profits of all corporations (red line) as reported in the National Income and Profit Accounts and adjusted for Inventory Valuation and Capital Consumption Allowances. The former is a relatively narrow-focused measure of profits, whereas the latter is very broad-based. NIPA profits hit a new all-time high as of June 30, 2010, whereas S&P profits at the end of Sept. '10 were still 15% below their August '07 high.
Despite their differences (apples to oranges, as skeptics would immediately notice), there is some remarkable similarity in the long-term behavior of these two measures of profits: both have increased by about the same amount over the past 50 years, and both show similar cyclical fluctuations. Plus, NIPA profits not only tend to lead reported profits, they are also much less volatile—despite being quarterly annualized numbers. Reported profits on a trailing basis are naturally lagging in comparison, but you would think they also would be less volatile as a result; that they are in fact more volatile suggests that reported profits are a less accurate indicator of profits on average than are NIPA profits. I note further that NIPA profits are based on information submitted by companies to the IRS, and as my good friend Art Laffer—who has been touting the NIPA profits number for decades—notes, no company is likely to overstate its profits on their IRS tax return. Key takeaway: The top chart has been and continues to suggest that reported profits are likely to keep increasing for the foreseeable future.
The second chart looks at PE ratios using S&P 500 reported profits. Here we see that PE ratios are somewhat below average. The third chart makes a similar case, but using NIPA profits and a normalized value of the S&P 500 as a proxy for the average value of US corporations. Here we see that PE ratios are quite low from an historical perspective. About as low, in fact, as they were at the onset of the great bull market of the 1980s.
This next chart compares the yield on long-term BAA corporate bonds (blue line) with the earnings per share (i.e., earnings yield) of the S&P 500 (red line). As I noted last month, earnings yields are now noticeably higher than corporate bond yields, another indication that equity valuations are relatively cheap. After-tax earnings on the S&P 500 stocks now represent a "yield" of just under 7%, which happens to be the average of the past 50 years. Corporate bond yields, in contrast, are currently 5.7%, which is 300 bps less than their average of the past 50 years. If it weren't for the market's obvious expectation that earnings are very unlikely to maintain current levels, much less increase, stocks would be considered an incredible bargain by historical standards.
If the NIPA profits are correctly predicting a continued and substantial rise in reported profits, then I have to believe that that the equity market has some very substantial upside potential, as either of the trend lines in the last chart are also suggesting.
Posted by Scott Grannis at 3:26 PM