Thursday, June 25, 2009

Equity prices have not kept up with profits

I've been arguing for a long time that U.S. equities were substantially undervalued. One of the reasons has been, and continues to be, the relatively strong underlying profits picture of U.S. corporations, as shown in this chart. The data for this chart come from the National Income and Product Accounts, and contain various adjustments which are designed to ensure that they reflect true "economic profits," not just those that are reported using GAAP. The y-axis for the red line (nonfinancial domestic profits) is exactly twice the scale of the y-axis for the blue line (total profits). That the two lines have changed by the same order of magnitude over the years shows, I think, that there are no other unusual factors involved (e.g., overseas profits, or the outsized losses of financial firms).

Simply put, profits have increased significantly since the last recession, and the decline in profits in this recession is not (at least so far) as bad as was the decline in the last recession, which was relatively mild. But as we also know, the level of equity prices has retreated to 1997 levels. So even if we take out the tech bubble that developed in the late 1990s, stock prices have lagged significantly the huge gains in corporate profits.

One obvious explanation for this is that the market is discounting some pretty awful, very bad, terrible news (e.g., Obama's spending, tax and regulatory policies, and/or the Fed's potentially inflationary monetary policy). And that means that any good news, such as even a modest recovery, should be very bullish for stocks.


alstry said...
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alstry said...


What is your view of this from Ritholtz's Blog:

“While the stock market is up sharply since early March, the economy as well as corporate earnings continue to suffer. Today’s chart helps provide some perspective as to the magnitude of the current economic decline. Today’s chart illustrates that 12-month, as-reported S&P 500 earnings have declined over 90% over the past 20 months (with over 90% of S&P 500 companies having reported for Q1 2009), making this by far the largest decline on record (the data goes back to 1936). In fact, real earnings have dropped to a record low and if current estimates hold, Q3 2009 will see the first 12-month period during which S&P 500 earnings are negative.”

bob wright said...

So am I interpreting the graph correctly: nonfinancial domestic profits have been close to half of total corporate profits.

Scott Grannis said...

That is correct

Scott Grannis said...

alstry: The profits that Ritholtz cites are GAAP profits, and that is very different from NIPA profits. Also, the methodology used to calculate S&P 500 earnings has been called into question successfully by Burton Malkiel, who demonstrates that if calculated correctly, profits would be much higher.

Stephen Chang said...

Scott, what's your thought in regards to profits as a share of GDP remain exceedingly high? I've been thinking that it needs to fall as we enter into a bigger govt and higher tax regime. However, I have not seen any evidence of that starting to correct yet?

alstry said...


Having owned a business or two in my day, I have found sales to be generally a better economic indicator of health of a business versus profits.

If a Depression is defined as a 10% decline in GDP peak to seems that we are getting very close to a Depression in a number of industries:

Auto Sales are DOWN around 50%.
New Home Sales DOWN over 75%.
Hotel Revenues DOWN over 20%.
Trucking Sales DOWN over 20%....rail not far behind.
Banking in TROUBLE....Credit Card Defaults OVER 10% and CRE imploding.
Commercial Construction coming to a grinding halt at the end of this summer.
Major Law Firms cutting staff at unprecedented levels.
Architectural Billings evaporating with not much on the books after August.
Government Tax Receipts off 20, 30, 40% and MORE!

With Government spend and health care being the last two major sectors of the economy relatively unaffected....based on what we are currently seeing in California...the tsunami is about to hit both.....

Putting the debate of profits aside, what are your thoughts that most will realize we have entered into a depression by the Fall of this year if the cuts in government spend are as material as currently contemplated?

__ said...

The obvious criticism is that the data is backward-looking. Arguably it's the outlook for profits that's important.

Anyway, Paul Miller's post on S&P earnings is worth reading, IMO:

Regards, MW

Public Library said...

I cannot help but wince when people start debating which way to skin a cat. If you think estimating corporate earnings is difficult, we should all quit and go home because the government figures on inflation, employment and the lot are a joke in comparison.

It is ironic how during the high flying days nobody bothered to mention that the entire market was using the wrong methodology to price securities and that this crisis has now brought forward a "new" way to slice the same old information.

This type of debate will fall by the waste side when things normalize and the market will be back to using the same old tried and true methodologies of yester year. To rely too heavily on any one measure is a mistake anyway.

Forward looking P/E ratios are 1 of hundreds of tools in the tool chest. Maybe we should publish all of the competing methodologies side by side each week so people can pick and choose which one matches their story more closely.

Oh wait, that is what the market does already!

Good golly!

狂猪 said...

I thought dilution maybe an explanation. However, I was wrong.

I just checked the s&p market cap.

The market cap today is

The market cap on 2/18/1998 is

You are right!