Thursday, May 26, 2011

Corporate profits remain very strong



As part of today's revision to Q1 GDP, we got our first look at corporate profits for the period. Total after-tax profits fell slightly from their fourth-quarter level, but as the charts above show, profits remain very strong nominally and relative to GDP. On an annualized basis and seasonally adjusted, after-tax corporate profits were $1.24 trillion, or 8.25% of GDP. In the past half century, corporate profits have only been stronger for a few quarters, in 2005-06.

It's a shame that despite the almost record-high level of profits relative to GDP, the federal budget deficit is even bigger. In fact, over the past two years, the federal deficit has totaled $2.7 trillion, while total corporate profits have been about $2.3 trillion. Considering that profits are money and money is fungible; that profits are a source of funds for the economy and deficit spending is a use of funds; this means the federal budget deficit has effectively absorbed every single dollar of corporate profits for the past two years. In my book, that goes a long way to explaining why economic growth has been so sluggish. Had the federal government not effectively appropriated the profits of the private sector to fund transfer payments and make-work projects, and to subsidize bloated state and local spending, the economy could have made tremendous progress and created millions of jobs in the process.


This next chart of PE ratios is constructed using a normalized S&P 500 index as a proxy for the value of all U.S. corporations, and after-tax corporate profits from the GDP tables as the earnings. What we see is that the equity market is trading at a fairly low multiple. Profits are very strong, yet multiples are distinctly below average. The only rational explanation for this is that the market does not believe that the current level of profits will be sustained. That may be the case, since it does appear that profits relative to GDP are a mean-reverting series (with profits averaging 6% of GDP over time), but nevertheless it shows that the market is very conservatively priced. The market is not making any heroic assumptions about the future of corporate profits, and instead is priced to the assumption that profits relative to GDP will decline significantly in coming years.


Looking inside the profits numbers, we see that nonfinancial domestic corporate profits rose significantly in the first quarter, which means that the weakness in the total number was confined to the financial sector. Also, as the above chart shows, nonfinancial domestic profits are unusually strong relative to total profits. The financial sector is still struggling in the wake of the recession, but the rest of corporate America is doing very well.

The biggest problem we have today is our bloated government, whose spending and borrowing needs are sucking the lifeblood out of the economy. Reducing the federal deficit by cutting spending would allow the private sector to reinvest the fruits of its labors, and that would in turn almost certainly fuel stronger growth.

5 comments:

Frozen in the North said...

Am I reading your right, the U.S. government is crowding out american corporation?

he federal deficit has totaled $2.7 trillion, while total corporate profits have been about $2.3 trillion. Considering that profits are money and money is fungible, the federal budget deficit has effectively absorbed every single dollar of corporate profits for the past two years.

Effective taxes paid by U.S. corporation at 9% of total tax revenues have never been lower, bank borrowings are still very sluggish.

Brian Gagnon said...

I think the true answer is that there is uncertainty about how sustainable those corporate profits are. Jack Hough suggested that we're in an invisible stock bubble. If that's the case,we might have reason to worry. If you're into online stock trading like me there are opportunities but you have to be careful and know when to get out. I hope I can stay on top.

Buddy R Pacifico said...

I agree emphatically about cutting federal spending. I disagree about corp pe ratios. It looks like pe ratios are reflecting stable growth and not irrational exuberance.

It will take very hard work and risks to just reduce the trajectory of fed spending. Real leadership will cut federal spending to eliminate deficits and reduce debt.

Bill said...

Spending is clearly a major problem and needs to be dramatically reduced.

Regime uncertainty also plays a large role in the lack of hiring by business. Businessmen do not know what to expect from the Obama crowd so they are sitting on their cash. It is an old fashioned capital strike caused by the buffoons in the Democrat party.

TradingStrategyLetter - Weekly Summary said...

You have beating the profit/earnings drum for a while. Ultimately that's all that matters. Nice work!