Tuesday, July 6, 2010

Corporate profits are strong, but pessimism rules

There's so much talk about a coming double-dip recession and the parallels between now and the 1930s that I feel compelled to counter the pervasive pessimism with some reasoned optimism.

The first chart here shows PE ratios as calculated by Bloomberg. As of June 30th, they stood at 14.9, which is below the long-term average of 16.7. As Brian Wesbury notes, if you use forward earnings estimates, PE ratios are now under 12.

Lots of pessimism in those figures, as I think you can see from the second chart, which compares profits according to the NIPA calculations (which in turn are based on IRS data), and standard earnings calculations based on what companies report using GAAP and writeoffs. I note that the NIPA measure of profits is much less volatile than the S&P measure, and to my eye the NIPA series tends to lead the S&P series. NIPA profits are just a shade below their all-time high (as of last March), while S&P profits are still almost 25% below their all-time high. If the NIPA series is indeed a leading indicator of reported profits, then there is plenty of good news on the profits front to come.

How reasonable people can look at these strong profits numbers and conclude that we are on the verge of another recession or even a depression is beyond me.

What we should be concerned about is not the absence of profits but the fact that while corporations are generally very profitable these days, they are noticeably very reluctant to invest those profits. Record levels of profits and tepid job creation is a sign of a lack of confidence in the business community, and it's not hard to understand why: consider the almost unprecedented anti-business attitude that emanates from the White House; the out-of-control federal spending that creates deep-seated fears of an eventual surge in tax burdens; the Congressional urge to dump huge new regulatory burdens on private industry; and the Federal Reserve's unprecedented purchase of $1 trillion of MBS, which creates a mountain of uncertainty in regards to future inflation and the value of the dollar. Here is a video of Steve Wynn making his views on the subject quite clear.


Public Library said...

Maybe the market is contemplating the sustainability and composition of those profits.

The financials, which are a large chunk of the s/p, benefited from free money and a vertical yield curve compliments of the Fed.

The rest of the country gets bilked out of its earnings potential by subsidizing the ponzi scheme with .25% rates on savings accounts.

It's no wonder things are headed south. I wonder what our grandparents and their parents would say about the state of affairs today...

Benjamin Cole said...

Could be a huge equity rally out there.

Bond yields will continue to come down--too much capital out there, not enough homes. At some point, bond investors will realize they are getting zero yield after inflation, and that is all they ever will get. A glut of capital.

So, money should move into property and equity.

When? Someday, baby, someday.

John said...


I think you are right but for the time being most market players are very pessimistic. Even if there is no double dip the economy could get stuck in a very low growth rut for awhile. Public Library has been warning of that develoment and he could very well be correct. I do not believe such a slow growth scenario should necessarily mean a long bear market for equities. We have had many slow growth periods with low inflation and high unemployment where equities performed well. I believe there are many headwinds that are different this time but quality companies with little/no debt and that have operations in many faster growing economies can do well over the next few years despite a US economy experiencing slower than optimal growth.

If we ever get a government that understands something about economics and how permanent employment is created we could have an equity boom as you say. It takes confidence in the future for that to happen. The bunch we have in Washington today IMO are not capable of building that kind of confidence. I fear the best we can hope for until more economily literate legislators are elected is slow growth and continued uncertainty about the future. It does not mean that one should exit the markets. It means investors should lengthen their time horizons, be prepared for volatility, focus primarily on dividend paying companies, and if you can, do some homework and cherry pick high quality companies when the market is throwing them away. Markets never move primarily in one direction forever, and one party rule in Washington won't last either.

Frozen in the North said...

Ok, I get the "blame Obama" thin, sure why not, but it remains that unemployment is high right now, around 9.5%, and U6 is even higher at 17.5%. Would that rather then profitability be the driver, high unemployment will slow GDP growth, since at the end of the day, its is consumption that drives GDP growth in the U.S. I suspect that this is what is driving the lower multiplier. Slower economic growth. I like your 3-4% GDP growth in the second half, don't know where its going to come from (Gov't are cutting, inventory cycle is over) still its nice to see a bullish outlook (no sarcasm intended).

brodero said...

One reason for the lag in S&P 500
profits versus NIPA profits is I believe the bad debt expense is considered a charge to the balance
sheet in NIPA accouning whereas S&P
500 accounting charges the income statement. Once the abnormal credit
costs are taken the two should move
closer together favoring the NIPA
number in this case.

Benjamin Cole said...

I am not defending Obama, but fact is regs and taxes were worse 1950-1980. We had an awful lot of good years in there.

Obama is not holding us back. The economy is weak--needs a jolt of monetary stimulus, bigtime.

I would rather live in an long inflationary boom than a long delationary recession.

For some reason, we have commentators calling for th latter scenario--out of habit, nearly.

Where is Reagan and Gilder when we need them?

John said...


What I am hoping for is a gradually improving economy over a several year period of time. I would love to see a boom right now but that just is not in the cards given the uncertainty coming out of Washington. For me it would be enough given the headwinds we face to have a 3% GDP this year and maybe a little stronger next. When a new government is elected perhaps at least we get gridlock and no more damage can be done. Companies have downsized and with productivity improving earnings can continue to go up giving us decent market returns. Three or four years of growing GDP even if its not 5 or 6% can be a good economy if inflation is held low. I think this is a scenario that has a decent probability of developing. It may turn out differently but I don't see anyone pointing this way. The scenarios getting the press now are far more dire.

Right now Obama is the President we have and we must live with him. But I have seen Presidents 'grow' with the job so maybe he can learn a few new things about how permanent jobs are created and at least stop scaring the he-- out of businesses. Low probability IMO but it could happen.

As long as the Fed's models are flashing GDP growth I really don't look for any more than they are doing. Monetary policy has a long lag and if the train is going in the right direction they will continue to wait for more data before doing anything drastic. Stimulative Fed policy has always brought positive GDP growth over time. I see no reason to think it will be 'different this time'.

I remain optimistic there will be no 'double dip'. The evidence (thanks so much to Scott for this) to me is conclusive. The risk now seems that growth is extremely low for awhile. This is IMO now fully discounted by the stock and bond markets. A growing economy with low inflation for the next several years is most assuredly not discounted. If that occurs, returns from equity investments from these levels will be well above average for some time. This is how I continue to see this playing out. If that changes, I believe it will show up soon enough in the economic data to give us ample warning. As of now, the economy is growing and this fear will soon pass as it becomes more obvious that another recession is not looming.

This should have a positive effect on property rents. We are still suffering from the aftershocks of the Lehman Bros debacle. Nerves are still frayed and confidence is weak. It will take time for the 'animal spirits' to return. I believe they will. More time without a catastrophe occuring will settle nerves and build confidence. Patience is the prescription for now...both for equity AND property owners.

Scott Grannis said...

Benjamin: you said "I would rather live in an long inflationary boom than a long delationary recession." I can assure you from personal experience that 1) booms don't happen when there is a lot of inflation, and 2) even if there were growth on top of a lot of inflation, you would not really prefer that to a low inflation economy. I lived in Argentina for four years during which time inflation was in the triple digits. It's awful. Living standards decline. Investment dries up. It hurts the average guy and the poor much more than anyone else. The only beneficiary is the state, which inflates away its obligations. In addition, I have spent many years studying how inflation impacts economies, and again I can assure you that a lot of inflation is not pretty.