Thursday, March 28, 2013
With today's release of revised GDP stats for Q4/12, we got our first look at corporate profits for the period. Although after-tax profits failed to post another record high, they have been increasing at a much faster pace than the overall economy for more than a decade. Since the end of 2001, profits are up 161%, for an annualized gain of 9.1%. In contrast, nominal GDP has grown by only 3.9% per year over that same period. It's rather amazing. Corporate profits have exceeded almost everyone's wildest dreams: since the end of 2008, profits have more than doubled.
I remember calculating back then that the market was priced to the expectation that about one-fourth of U.S. corporations would be bankrupt within 5 years, and that corporate profits would decline by almost two-thirds. In short, the market was priced to an end-of-the-world-as-we-know-it scenario. But here we are 4 years later, and instead of a huge collapse in profits, we have seen a doubling of profits! This explains the rise in the stock market in the past 4 years, even as the recovery has been the most miserable one on record: the future has turned out to be much better than expected.
But still the market remains pessimistic, extremely reluctant to believe the good times will last. Why? Here's one explanation: As the second chart above shows, profits have averaged just over 6% of nominal GDP for the past 50 years or so, and that has created the expectation that profits will inevitably revert to that mean.
The above chart shows the PE ratio of the U.S. stock market using total after-tax, adjusted corporate profits from the National Income and Product Accounts as the "E" and the S&P 500 index as the "P." (I've used a normalized S&P 500 index to make the ratio similar on average to the actual PE ratio of the S&P 500, which averaged a little over 16 during this same period.) Note that this measure of the PE ratio of U.S. corporations at the end of last year was about 30% below its long-term average. With the S&P 500 today reaching its former all-time closing high, and assuming corporate profits have not grown at all this quarter, this PE ratio today would be 11.8, still about 25% below the long-term average.
By this measure, stocks today are extremely attractive. (The conventional calculation of the PE ratio of the S&P 500, using 12-month trailing earnings, is 15.4 today, about 7% below its long-term average.)
What explains the undervaluation of stocks today? I think it's the expectation that corporate profits will revert to their historical average of about 6-6.5%% of GDP. This might take the form of corporate profits declining by one-third in the near term, or not growing at all for the next 10 years while nominal GDP posts average growth. Either scenario would qualify as extremely pessimistic, albeit consistent with a mean-reversion of profits relative to GDP.
Once again I'll advance the notion that while corporate profits appear to be unsustainably high relative to the size of the U.S. economy, they are at fairly average levels when compared to the size of the world economy. The U.S. economy today is much more integrated with the rest of the world than ever before, and for most large corporations, international sales are an increasingly important source of total profits. The global economy has grown much faster than the U.S. economy in recent decades, so it is only natural that U.S. corporate profits have also grown much faster than the U.S. economy. There needn't be a big mean reversion; profits might even continue to grow, or at least not decline relative to nominal GDP in the future.
Conventional thinking sees unsustainably high corporate profits and expects a reversion to the mean. Global thinking sees no a priori reason to worry at all.
Posted by Scott Grannis at 10:53 AM