With the recent revision to third quarter GDP, we see that corporate profits after tax hit a new record high of $1.22 trillion. Relative to GDP, profits have only been higher in six of the past 209 quarters. As I've noted before, what strikes me most about the corporate profits picture is that today the S&P 500 is unchanged from where it stood in November 1998, yet after-tax corporate profits have surged 120% since the end of 1998.
In this next chart, I have used a normalized S&P 500 index as the "P" and NIPA after-tax profits as the "E" to generate a history of PE ratios. (These ratios are not meant to be comparable to the PE ratios you see for the S&P 500 based on reported profits, but they do give you an idea of how the market's valuation has changed over time.) This exercise shows that stocks were clearly overvalued in 2000, as we now know, and it also shows that stocks have rarely been as undervalued as they are today. Indeed, by this measure they are almost as cheap as they were in the early 1980s, on the eve of what later proved to be a two-decade-long equity boom. The only explanation that makes sense for why stocks are so cheap today is that the market is expecting interest rates to rise, tax burdens to rise, and corporate profits to fall—all of which would contribute to severely depressing the discounted present value of future after-tax earnings. If your crystal ball is not so pessimistic, then stocks are a buy.
Nominal GDP is now at a record high as well, having fully recovered from the recent recession. Real GDP is only 0.6% below its late-2007, and if the 2.5% growth rate of Q3/10 is repeated in the current quarter (a safe bet, is my guess) then real GDP will hit a new all-time high in just five and a half weeks.
As this next chart implies, profits have been strong not only for nonfinancial companies, but for the financial sector as well. As Brian Wesbury notes, "The gain in profits in Q3 was mostly powered by domestic financial companies, whose profits increased at a 46% rate."
This next chart compares NIPA profits to S&P 500 earnings per share. As should be evident, NIPA profits are not only more stable than reported profits, but they also have a strong tendency to lead reported profits. The very strong recovery in NIPA profits since late 2008 thus portends further substantial gains in reported profits, which were up 34% in the 12 months ended October. All in all, some very encouraging news for equity investors.