Wednesday, June 3, 2009

Corporate profits are still quite healthy

This could be one of the most amazing charts to come out of this recession, which in my estimation has basically ended. With data through Mar. 31, 2009, it shows that, since the last recession, corporate profits have doubled, while nominal GDP has grown only 40%. As a percent of GDP, corporate profits today are higher, relative to the size of the economy, than they have been in 165 out of the past 200 quarters (i.e., higher than about 40 of the past 50 years). Yet the market capitalization of the equity market today is no higher than it was 12 years ago—1997—well before the days of "irrational exuberance."

Note: I'm using corporate profits as they figure in the National Income and Product Accounts. They are adjusted for inventory valuation and capital consumption allowances. These represent the true economic profits of all corporations, and historically they have been less volatile than standard GAAP profits (see next chart).

Bottom line, this recession seems to have hit consumers and workers the hardest, but has not put an outsized dent in corporate profits. That equity prices should still be as low as they are is the real issue, and probably reflects several factors:

1) The expectation that enormous increases in government spending under the Obama administration (and with no revenue yet identified for a proposed $600 billion expansion of federally-funded healthcare) will bring with them equally enormous increases in taxes. Obama is planning to increase the federal government's share of GDP by 20-25% over the next few years, which means effective tax burdens on the private sector could rise by a similar amount. Since equity prices are equivalent to the discounted, after-tax value of future corporate profits, the expectation of a significant increase in taxes could be depressing equity prices substantially.

2) Fears that a sizeable expansion of the public sector relative to GDP could result in a slowing of the economy's potential growth rate in the future. To me—and to Milton Friedman—it is axiomatic that the larger the government's share of total spending, the less efficient the economy will be. And as the economy becomes less efficient, then productivity grows at a slower rate and that means a slower rate of real growth in the economy. This expectation, in turn, would mean a slower rate of growth for all future corporate cash flows, and that would also depress equity prices today.

3) Fears that the Federal Reserve's almost incomprehensible expansion of its balance sheet, coupled with repeated promises that it will continue to purchase Treasury and mortgage-backed securities in order to keep mortgage rates low—and thus monetize the swelling federal debt—will eventually result in a substantial increase in future inflation. Higher inflation would inevitably lead to a tightening of monetary policy, and at some point that would all but ensure another recession (all recessions in the past 40 years have been the by-product of tight money). Fears of another recession at a time when we haven't officially exited the last recession could well be adding to the equity market's gloom.

4) Lingering fears that we haven't seen the worst of the housing market debacle (e.g., rising mortgage defaults could lead to even lower home prices), and that if things got much worse the stability of the financial system would again be called into question. In other words, fears that we haven't seen the end of the current recession.

In short, the market has some legitimate concerns that could easily justify why equity prices are so cheap. Being the optimist that I am, I think these fears will be alleviated by 1) continued evidence that the economy is again growing, albeit slowly, 2) Congress encountering difficulties and/or delays in passing healthcare reform and/or a cap and trade reduction in carbon emissions, 3) mounting resistance to higher taxes, and/or 4) mounting pressure to roll back some of the February "stimulus" spending which essentially hasn't even gotten off the ground yet. Consequently, I remain optimistic.


Mark A. Sadowski said...

There are diminishing returns to scale with everything, including corporate profits. This should be a worrying sign, not a sign of a healthy balanced growing economy.

And the best sign for the health of the economy going foreward would be a resolution of the rampant health care cost crisis which has plagued the economy with dreaded uncertainty for nearly 20 years now.

Scott Grannis said...

Mark, if corporate profits are still relatively strong, then a return of confidence could unleash a flood of investment spending and that would really be positive for the economy.

The health care crisis is a crisis only in the minds of the politicians. The real crisis will come when we have to pay for a universal healthcare system and cope with the rationing of care that will necessarily follow.

In any event, I think there are some very simple and powerful "cures" for the healthcare mess that we have.

Going to a universal healthcare system is scaring the heck out of the market because it means a lot more government and a lot more taxes.

Jon S. said...

Scott -- I've been absent from commenting for a while but are still reading your blog most days. And you are not being unclear at all. Mark, as usual, is either deliberately obtuse or merely a partisan hack for Obanomics -- or both.

Despite some extremely debatable commentary and disparaging comments about monetary theorists, Martin Wolf (Mark's citation) ultimately agrees that the Fed needs to tighten at some point -- and sharply! So much for the small to zero impact of monetary policy, eh?

That we've seen so much improvement across the board, despite the coming horrors and despite virtually no stimulus spending, demonstrates the folly of the first few months of Bambi's presidency. No help of any sort for the economy re spending, but a downpayment on years of permanently growing government and ruinous rates of taxation.

Jon S. said...

Ooops -- I posted a comment on this thread instead of on the 'Recall the Stimulus' thread.

Oh well -- as long as I'm here again, I'd love to hear the estimable Almost-Doctor Sadowski explain to us exactly how health care costs have been a crisis, how it's been rampant, and how it's plagued our economy for twenty years now -- an economy that's more than doubled in real terms, even despite the Sept market crash, in the past 20 years.

Public Library said...


This is a well balanced post.

I think the markets are properly discounting the future possibilities of US growth with neither a more bearish nor bullish slant.

The reality of the debt binge and bailout bonanza has clearly given investors a reason to pause.