Today's revision to Q3/13 GDP gives us our first look at corporate profits for the quarter, and they just keep on growing. Nominal after-tax profits are at a new all-time high, and have risen almost 9% in the past year. This is very impressive no matter how you look at it.
The two charts above show after-tax corporate profits and nominal GDP; the first chart takes the long view, while the second chart zooms in on the past quarter century. The y-axes of both graphs have similar ranges, so it should be apparent that corporate profits have risen at a much faster pace than nominal GDP both in the current recovery and over the past two decades.
The chart above shows after-tax corporate profits as a % of nominal GDP. Profits are very close to an all-time high on this basis, and significantly above where they have been over the past 55 years. It's been my view for the past several years that the market looks at this chart and sees a mean-reverting phenomenon, and thus expects profits to revert to 6-7% of GDP over the foreseeable future. This implies that the market has very little confidence that profits will continue to increase, and is very worried that profits could suffer a significant decline, both nominally and relative to GDP, in coming years. That's why PE multiples are only average despite the fact that profits are at record levels. (Last August I explained this in more detail.)
In effect, the market is priced to a significant deterioration in the profits outlook. Yet profits continue to defy their presumed mean-reversion tendency and continue to increase. Profits will undoubtedly decline when we suffer the next recession, but that might be years away. Worrying about an imminent recession is characteristic of this entire recovery, as I explained yesterday ("The most risk-averse recovery ever"). But so far, the pessimists have been missing out on a fabulous equity rally.
The chart above shows the PE ratio of the S&P 500 index using NIPA profits (the BLS's calculation of total economic after-tax corporate profits). I've normalized the S&P 500 index so that the average PE ratio using this method is similar to the long-term average PE ratio of the index using reported corporate profits. Here we see that PE multiples are significantly below their long-term average, whereas the reported PE of the S&P 500 is about average (see chart below). I explained the reason for the differences in these two PE ratios, and their rationales, here.
In short, this market continues to be very skeptical of the future. Very risk averse.