Wednesday, November 30, 2016

Corporate profits are still healthy

The collapse of oil prices that began over two years took a big bite out of corporate profits, but now that oil prices have been relatively stable for the past year or so, corporate profits are rebounding. Profits are still below their previous highs, both nominally and relative to GDP, but they are still healthy from an historical perspective. Using the measure of corporate profits that comes from the National Income and Product Accounts as the E, and the S&P 500 index as the P, PE ratios are only modestly above their long-term average.


The chart above shows after-tax corporate profits (for all corporations), adjusted for capital consumption allowances and inventory valuation. This is considered to be the best measure of "economic" profits over time, as distinct from FASB profits. Note that profits are up over 13% in the past nine months, and were only briefly higher in the period just before oil prices collapsed. Note also that profits have tripled in the past 16 years, over which period the S&P 500 rose only about 50%.


The chart above compares this same measure of profits to nominal GDP. For the past 70 years or so, profits have averaged just over 6% of GDP. Today they stand at 8.5%. (The y-axes of the above graph are set so that the red and blue lines intersect when profits are equal to 5% of GDP.) For years, stock market skeptics have argued that profits were mean-reverting, and would inevitably fall from the 8-9% levels relative to GDP that were achieved in late 2009 and early 2010. That has not happened. I've theorized for years that profits can sustain a level relative to GDP that is higher than what we saw prior to the late 1990s because of globalization: U.S. firms are now able to address a market that is significantly and permanently larger than it was prior to the mid-1990s. As an example, consider that since the mid-1990s, U.S. international trade has roughly doubled in size relative to GDP, from 6-7% to almost 15%.


If NIPA profits are superior to FASB profits, as Art Laffer has argued for decades, then it makes sense to use NIPA profits to calculate PE ratios. The chart above does just that, using NIPA profits as the E, and the S&P 500 index as the P. (The S&P 500 index is arguably a reliable proxy for the valuation of all U.S. corporations.) I've normalized the numbers so that the long-term average of this series is equal to the long-term average of PE ratios as calculated by Bloomberg, using adjusted FASB profits. Here we see that PE ratios are only slightly above average (17.5 vs. 16.5).

At the very least, these charts support the notion that stocks are not egregiously overvalued, as many continue to argue.

10 comments:

Benjamin Cole said...

Terrific post.

Relatively, corporate profits are near record highs and much higher than they were even in the recent past, such as the Reagan or Clinton years.

Good! I hope profits rise from here.

OT but interesting:

Steve Mnuchin, President-elect Donald Trump’s newly-minted pick for treasury secretary, said Wednesday that any upper-income tax cuts enacted by Trump would be offset by eliminating tax deductions.


“Any reductions we have in upper income taxes would be offset by less deductions so there would be no absolute tax cut for the upper class,” Mnuchin said in an interview on CNBC’s “Squawk Box.”

Mnuchin argued it was “not the case at all” that most of Trump’s proposed tax cuts would benefit the upper class.

“There will be a big tax cut for the middle class, but any tax cuts we have for the upper class would be offset by less deductions that pay for it," he said.

Benjamin Cole said...

Terrific post.

Relatively, corporate profits are near record highs and much higher than they were even in the recent past, such as the Reagan or Clinton years.

Good! I hope profits rise from here.

OT but interesting:

Steve Mnuchin, President-elect Donald Trump’s newly-minted pick for treasury secretary, said Wednesday that any upper-income tax cuts enacted by Trump would be offset by eliminating tax deductions.


“Any reductions we have in upper income taxes would be offset by less deductions so there would be no absolute tax cut for the upper class,” Mnuchin said in an interview on CNBC’s “Squawk Box.”

Mnuchin argued it was “not the case at all” that most of Trump’s proposed tax cuts would benefit the upper class.

“There will be a big tax cut for the middle class, but any tax cuts we have for the upper class would be offset by less deductions that pay for it," he said.

Scott Grannis said...

It's unfortunate that Mnuchin has set off on the wrong foot before even being confirmed. It's good that he wants to eliminate deductions as a way to pay for lower marginal rates; a flatter tax structure is always preferable, and deductions only serve to distort the economy. But he seems to be ruling out the gains that could be achieved by dynamic scoring of net tax cuts. Dynamic scoring would recognize that net tax cuts would strengthen the economy and that would serve to offset the effect of cutting rates. Also, the bulk of tax collections come from "the rich," and roughly half of taxpayers pay no income tax; therefore tax cuts perforce have to "benefit" the rich more than the middle class. He's boxed himself into a populist paradigm. We can only hope that the tax reform process will deliver better results than what he is promising.

Benjamin Cole said...

Scott:

I think you are being a little harsh on Mnuchin.

As you say, a lower top marginal rate, without the complications (read special interest distortions) of deductions, is a positive. He did not rule out dynamic scoring, at least that I have read.

That said, tax cuts for middle class make sense. We want to incentive-ize working, and we need larger aggregate demand. Tax cuts on the middle class do that.

I would like to see reduction in social welfare outlays, from food stamps through the VA through rural subsidies, along with tax cuts on the middle class, but then I would like pie in the sky too. Sometimes if you can get a slice of the pie, you have to take that.

There is a GOP Congress and maybe Mnuchin and Trump can move forward. Certainly, Mnuchin is a smart guy, business-finance background.

As you say, Trump as a person has many flaws (as do I), and he made many regrettable statements. How he won (even in the tilted Electoral College) is beyond me. I think he won on the middle-class vote. Worth remembering.

On economics? Trump may be a winner. Stock market is up. Boosting spirits in America's huge middle class cannot be a bad move.

steve said...

I'm a little surprised you haven't commented on the Carrier AC news. Leaving 1000 jobs in the US is the good news. the BAD news is higher costs for consumers and if you extrapolate this across industry the cost is indeed high and to benefit how many? 1-2% of the population? probably note nearly that many. not to mention the hit that CAPITALISM itself takes. I find it hard to be overly sanguine about a DT presidency.

Scott Grannis said...

Re Carrier and Ford keeping jobs in the US: the way I see it, these were "deals" that gave the companies legitimate incentives (in the form of reduced taxes) to keep jobs in the US. I don't see evidence of coercion. If we cut corporate taxes to 15% I'm sure lots of companies would discover that US jobs were once again competitive. Sure, maybe some coercion/jawboning was likely involved, but so far we're talking only about very small numbers. Let's see how these things play out in Congress (where the lower tax rates and reduced regulatory burdens have to come from) next year before jumping to conclusions.

Oeconomicus said...

Scott- What do you think of the Total Market Cap to GDP ratio that Warren Buffett espouses as the single best metric for stock market valuation?

William McKibbin said...

I sure hope Scott is right about stocks...

Scott Grannis said...

Re: Buffett's valuation metric: Nobody has an iron-clad method for determining when stocks are too pricey or too cheap, but it's hard to resist the exercise. From time to time I've posted a chart that shows the ratio of the S&P 500 to GDP, and the 10-yr Treasury yield. Valuations tend to move inversely to yields: high yields in the late 1970s saw very low valuations, and today's relatively low yields correspond to much richer valuations. But all that says is the the market tends to discount future earnings using with the 10-yr yield. That chart currently suggests that valuations are roughly "fair" to perhaps a bit "cheap" given the current level of yields. The stocks/GDP ratio today is around the same level as it was in the 1955-70 period, but the 10-yr is lower now than it was then. Perhaps that further suggests that the market is assuming the 10-yr will move higher and is using that higher discount rate to value stocks today.

William McKibbin said...

The US economy is in trouble -- war -- tariffs -- trade deficits -- national debt -- watch for minimum 40% declines in the DJIA, bonds, real estate, and precious metals beginning in 2017 and extending into 2022 and beyond -- I sure hope I am wrong...