Thursday, March 8, 2012
I've showed this chart many times over the past several years, usually in the context of how impressive the growth in profits has been since the late 1990s, and usually with the observation that despite all this profits growth, equity prices are almost unchanged. To be specific: since October 1999, corporate profits after taxes have increased 160%, yet the S&P 500 index is unchanged. Many readers and analysts have argued that this is no anomaly, since the market is simply figuring that corporate profits will soon revert to their mean relative to GDP (6%); that the burst of profits in recent years is only transitory. My own valuation models confirm this: I think the market is priced to the assumption that Treasury yields rise significantly and corporate profits decline to 6% of GDP in the next 3-5 years. I've argued that since this is such a pessimistic assumption, there is plenty of room to be optimistic. Skeptics have argued that corporate profits can't possibly remain as strong relative to GDP as they are today, much less continue to increase, and that they must decline significantly in the years to come.
Now, reader "WimpyInvestor" has asked a question that bears looking into: "if US corporations are serving global customers, then shouldn't the denominator be changed to Global GDP?" And indeed I think he is right. The increasing globalization of world commerce has brought with it spectacular opportunities for companies to expand their addressable market. Apple is a prime example, since it can sell the same iPhone all over the world, and the global cell phone market is now over 6 billion in size, compared to less than a billion not too many years ago. Hollywood is another example of an industry that can now sell its products to billions of customers, whereas the movie-watching market was less than a billion a decade or so ago. It no longer makes sense to compare the profits of U.S. corporations to U.S. GDP, since that arbitrarily limits the effective size of the market our corporations operate in. It's time to go global in our thinking. Never before have companies been able to market their products so easily to such a huge and rapidly growing global market.
And so I've put together the above chart, which compares the same measure of corporate profits (after-tax adjusted corporate profits according to the National Income and Product Accounts, which includes income from foreign sources) to World GDP as calculated by the World Bank. (I've made a conservative estimate of world GDP for 2011.) Now we see that corporate profits aren't really so high after all. When we consider that many U.S. corporations now have significant exposure to global markets, profits relative to world GDP are only slightly higher today than they have been on average over the past 50 years. A reversion to the mean might occur over the next two years without any decline at all in nominal profits; for example, profits could continue to increase by 5% a year, but global GDP is likely to increase by even more (e.g., nominal GDP growth in China and India is likely to be in double-digit territory).
I think this adds up to one more, and very good, reason to think that the U.S. equity market is being way too pessimistic in its outlook for corporate profits.
Posted by Scott Grannis at 10:13 AM