Thursday, March 28, 2013

Corporate profits remain strong

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.


Gloeschi said...

So mean reversion is "extremely pessimistic"? Is that what they tell on CNBC?

Joseph Constable said...

You can’t tell anything about the economy from NIPA “derived” corporate profits. It is a good piece of data for stock market psychology, however.

Here is the relevant quote from Econoday making the report economically non-relevant. “The corporate profit figures that are derived from the national income and product accounts (NIPA) depend on GDP growth. They don't always move in the same direction or the same magnitude as the profit data reported directly by individual companies or even the S&P 500.”

From S&P quarterly earnings for the 500 - after tax earnings, not operating earnings, with 99.3% reporting for Q4’13 as of 3/21/13:
Q4’12 $20.60
Q3’12 $21.21
Q2’12 $21.62
Q1’12 $23.03
Q4’11 $20.64

“Not even in the same direction” is right. Derived profits. Give me a break. The 500 profits are down yoy and the government tells us corporate profits are up over 13% yoy.

Now you know why the Fed did QE4. They didn’t believe the government data.

Thank heavens the S&P500 is projected to have Q1’13 profits of $25.02, or 21.5% growth over the 4th quarter. The economy is saved. Thank you Ben Bernanke for the $255 billion pumped into the economy in the first quarter. These are joyous times.

Benjamin said...

Shareholder activism is another reason to think about equities.

People forget, that pre-Michael Milken, many public companies were run like fiefdoms for management, or even country clubs. I never saw a nicer place than ARCO's HQ top floors.

Now, there are shareholder groups that will "take a company private" and do what management won't do. Unfortunately, management usually gets enriched along the way, but what can you do....

The Dell situation is promising...companies may be worth more than the market thinks.

The threat is not from public companies, which are probably better run than ever, but from a ballooning federal agency spending and a Federal Reserve that may see us into another recession even before we get out of zero bound. Then what will the Fed do? And what will happen to federal deficits?

Japan, here we come?

I will say, property looks pretty good for the next couple of years. Find a house, dude it up. You will probably make a huge return on equity.

Divsurgeon said...

Good summary!

Joseph Constable said...

“Dude it up”

On my daily walk, half way between SF and SJ, California, this is, mid-peninsula, I have been watching a house get fixed up for sale. The original house was an 1100 sf two bedroom one bath with a detached one car garage. Old as the hills. They widened the garage to be a small two car garage and built three bedrooms, two on top of the garage and one over the back of the house. It is now a three bedroom, two bath house. The downstairs is an expanded kitchen with a separate dining room, and the living room. They kept the bathroom. The second bathroom is shared by all three bedrooms upstairs. The place is as neat and clean with fully upgraded amenities as you can get. But I was surprised the day they put out the box with the information sheets in it to find they were asking $1,220,000.

Joseph Constable said...

I have a serious question.

TCMDO Total Credit Market Debt owed is $56 trillion. Money supply is $10 trillion. How can that be? There must be credit velocity as there must be a higgs-boson.

The mechanics of money velocity are simple. I can't figure out the mechanics of credit velocity.

I know there is re-hypothecation of the same collateral. But I doubt that explains it all.

William McKibbin said...

I believe that corporate profits will continue to improve, especially given that real labor costs are regressing to global norms (and have been for the past 40 years) -- the stagnation and/or decline in real working wages in the US is great news for profits.

ChronicleSmith said...

I would be interested in your comments on this article by David Stockman in Sunday's NYT.

Thanks in advance,

Bill Smith

P.S. I remain convinced that the Aussie buck is still at your indicated overvaluation.