Wednesday, November 26, 2014

Corporate profits juggernaut continues

In my view, one of the most enduring and extraordinary features of the current business cycle expansion has been the strength of corporate profits. According to the GDP stats released yesterday, third quarter after-tax corporate profits hit a new nominal high of $1.87 trillion, and a new high relative to GDP of 10.3%. So it's no wonder that equities are hitting new highs. Indeed, despite profits hitting all-time record highs, PE ratios today are only slightly above average. Stocks by this measure still look quite attractive.

From 1958 through 2004, after-tax corporate profits averaged about 5.3% of GDP. Since then, and including the profits collapse of the Great Recession, after-tax corporate profits have averaged 8.8% of GDP. As the chart above shows, over the entire period since 1958, corporate profits have averaged about 6% of GDP. For the past 5 years, equity bears have in effect argued that profits were unsustainably high because they had a strong tendency to be mean-reverting to, say, 6% of GDP. Instead, profits have just continued to grow, both nominally and relative to GDP. A pessimistic outlook for corporate profits has essentially been the driving force behind the equity market's gains, because profits have far exceeded expectations. In a sense, the market has been forced higher because profits have been much stronger than expected. 

I argued in an earlier post that profits needn't revert to their historical mean because the world has fundamentally changed. Successful U.S. corporations can now more easily address a far larger market, thanks to globalization:

Global profit margins haven't budged for over 10 years. What's happened is that world GDP has grown much faster than U.S. GDP, and U.S. corporations have cashed in on the boom. Today, a greater portion of corporate profits is coming from overseas, where markets and opportunities are much more dynamic than here at home. Apple can sell iPhones to billions of customers all over the world today, whereas it could only address a much more limited market in the past—primarily the developed countries. Seen from this perspective, there is much less reason to worry about stagnant or declining profits.

But perhaps I'm mixing apples and oranges here, because my source for corporate profits in the first chart in this post is the National Income and Products Accounts (i.e., the GDP stats), instead of the more-commonly referenced reported (GAAP) earnings. As the chart above shows, after-tax corporate profits according to NIPA data have been much stronger over the past decade than profits reported according to GAAP data. I addressed a few reasons for the difference in the behavior of these two measures of profits in a post last year (i.e., changes in accounting standards and changes in taxation regimes). Moreover, NIPA profits are derived from corporate tax returns filed with the IRS, and as such are not impacted by things like "goodwill." Regardless, as the chart above shows, earnings by either measure have been increasing fairly steadily over the past five years, and both are at new highs.

Let's stipulate for the sake of argument that GAAP earnings are what everyone focuses on, and they are the better measure to use when valuing equities. What we get is the chart above, which calculates the PE ratio of the S&P 500. Today it is 18.3, which is only slightly higher than its long-term average of 16.2. If earnings are at new nominal and relative highs, and multiples are only moderately above average, that hardly supports the case that equities are overvalued, as the bears currently believe.

In the chart above I've used NIPA profits instead of GAAP profits to calculate the PE ratio of the S&P 500. (I've normalized the results so that the long-term average is 16, so that it can be compared easily to the prior chart.) Here we see that equity multiples at the end of the third quarter were about average. The real equity market bubble happened in the late 1990s, but it was thoroughly popped.

Another way to value equities is to compare their earnings yield (earnings per share divided by share price—the inverse of the PE ratio) to the yield on risk-free Treasuries. That's shown in the chart above. Although the current equity risk premium is a lot lower than it was several years ago, it is still substantially higher than its long-term average. In order to remain indifferent between holding equities or holding 10-yr Treasuries, investors today are demanding a yield that is more than 300 bps higher than the yield on 10-yr Treasuries. That's solid evidence that the market is still quite risk-averse. In the heady growth days of the 1980s, stocks were so in demand that investors were content to accept an earnings yield that was much lower than the yield on 10-yr Treasuries. If investors were enthusiastic about the outlook for earnings today, earnings yields would be lower relative to Treasury yields.

Yet another comparison that is instructive: comparing the ratio of the S&P 500 index to GDP, and that ratio to the inverse of the level of 10-yr Treasury yields, as shown in the chart above. That the two lines tend to move together is a sign that equity valuations tend to be higher as yields are lower, and vice versa. This fits with the theory that equity prices are the discounted present value of future earnings, so lower discount rates (i.e., Treasury yields) imply higher equity valuations. As the chart suggests, equity pricing is not out of line with Treasury yields. If anything, prices could be higher still. Alternatively, this could be taken as a sign that equities today are priced to the expectation that Treasury yields will move substantially higher (i.e., the market is priced to bad news).

Conclusion: there is still a lot of risk aversion to be found in the pricing of Treasuries and equities. This is a good sign that the equity market is not over-valued and may still be attractive.

Update: Quantitative Easing didn't "lift" the stock market; strong corporate profits did—that's a big difference for one's world view.


Matthew Grech said...

The persistency of super-high corporate profits as a percentage of GDP has been one of the most intriguing stats of recent years and is, I believe, the flashpoint of the disagreement between bulls and bears.

I've wondered why it has stayed so high for so long. Scott, I found your explanation of globalization to be a little, uh, incomplete.

My best guess is that it largely has to do with the reduction in the number of major players in virtually all industries as well as the paucity of new business creation in recent years. There are many examples, but the consolidation within the airline industry is an obvious one.

Too, there seems to be widespread unwillingness to form new businesses to compete with entrenched players. Again, think of the airline industry. It wasn't that long ago when a new airline was formed on a regular basis.

Also, it seems like it has become far more difficult for businesses to deal with all the red tape - regulations, environmental dictates, etc. - such that big players have gotten bigger (because they can throw an army of lawyers at these issues) and new players are less apt to try.

Basically, most industries seem to going in a more oligopolistic direction. So pricing and margins have been fantastic.

Low levels of new business formation as well as too-low levels of corporate capex are likely the reasons behind these historically high corp margins. And they're probably sustainable too. But it does make me wonder about the longer term business climate in the US.

Benjamin Cole said...

Interesting post. Corporate profits are at all-time record highs, even relatively.

I think global competition is ferocious, so I am not inclined to the idea that less competition explains profits.

I think aligning of management with shareholders explains some of it. Compared to the country-club boards and fat management of yesteryear, today's companies are well-managed.

Shrink government.

Joseph Constable said...

While companies may be better managed today, they certainly have become expert in limiting supply optimally for higher prices.

In the previous post it is pointed out that oversized profits lead to increased supply. The supply curve shifts.

Oligopolies have learned how to not shift it.

The Wall St. Journal reports 12 month trailing PEs as of 11/28:
Dow 30 16.93
Russel 2000 61.40
Nasdaq 100 25.14
S&P 500 19.43

With 97.5% reporting the 500 earned (GAAP) $106.08 for 4 quarters ending 9/30/14. That is an increase of 12.4% over 4 quarters ending 9/30/13.

High growth is justification for high PEs. Enthusiasm is muted exactly because of the global reach of the 500. It is thought there will be a slowdown.

William said...

A good portion of the enthusiasm for equities seems to be bases upon two beliefs: 1) there is no other place to put one's money and 2) profit margins will remain unusually high and NOT revert to the mean.

To me it seems that all the "economic surprises" are negative ones: Japan is in recession again, China's manufacturing and GDP grow was less than expected, Germany's manufacturing unexpectedly fell, natural resources, oil and materials prices have fallen off cliffs, etc.

In bull markets, the economic surprises are to the up side - not the down side.

Kevin Erdmann said...

Interesting post, as usual.

I have done some work on this. You are clearly right about globalization. An increasing share of corporate income is coming from international sources. When this is corrected for, the level of domestic profits is more subdued.

I think there is an additional issue that you haven't addressed here. Free Cash Flow to the Firm goes to debt and equity. Capital includes both. Much of the recent increase in corporate profit is due to deleveraging related to the risk aversion that you refer to in your post.

If you add up domestic profit and interest income, they cycle around a level trend for the past 30 years. Add in proprietors income, and the trend is flat with cyclical noise since WWII.

Here's a post I wrote on the topic: