Monday, October 4, 2010

Profits outlook--still bright

With the end of the third quarter behind us, it's time to update what we know or can infer about corporate profits and stock market valuations.

The top chart compares trailing, after-tax, 12-month profits (earnings per share) as reported by the S&P 500 (blue line) for September, with the annualized (Q2/10) after-tax profits of all corporations (red line) as reported in the National Income and Profit Accounts and adjusted for Inventory Valuation and Capital Consumption Allowances. The former is a relatively narrow-focused measure of profits, whereas the latter is very broad-based. NIPA profits hit a new all-time high as of June 30, 2010, whereas S&P profits at the end of Sept. '10 were still 15% below their August '07 high.

Despite their differences (apples to oranges, as skeptics would immediately notice), there is some remarkable similarity in the long-term behavior of these two measures of profits: both have increased by about the same amount over the past 50 years, and both show similar cyclical fluctuations. Plus, NIPA profits not only tend to lead reported profits, they are also much less volatile—despite being quarterly annualized numbers. Reported profits on a trailing basis are naturally lagging in comparison, but you would think they also would be less volatile as a result; that they are in fact more volatile suggests that reported profits are a less accurate indicator of profits on average than are NIPA profits. I note further that NIPA profits are based on information submitted by companies to the IRS, and as my good friend Art Laffer—who has been touting the NIPA profits number for decades—notes, no company is likely to overstate its profits on their IRS tax return. Key takeaway: The top chart has been and continues to suggest that reported profits are likely to keep increasing for the foreseeable future.

The second chart looks at PE ratios using S&P 500 reported profits. Here we see that PE ratios are somewhat below average. The third chart makes a similar case, but using NIPA profits and a normalized value of the S&P 500 as a proxy for the average value of US corporations. Here we see that PE ratios are quite low from an historical perspective. About as low, in fact, as they were at the onset of the great bull market of the 1980s.

This next chart compares the yield on long-term BAA corporate bonds (blue line) with the earnings per share (i.e., earnings yield) of the S&P 500 (red line). As I noted last month, earnings yields are now noticeably higher than corporate bond yields, another indication that equity valuations are relatively cheap. After-tax earnings on the S&P 500 stocks now represent a "yield" of just under 7%, which happens to be the average of the past 50 years. Corporate bond yields, in contrast, are currently 5.7%, which is 300 bps less than their average of the past 50 years. If it weren't for the market's obvious expectation that earnings are very unlikely to maintain current levels, much less increase, stocks would be considered an incredible bargain by historical standards.

If the NIPA profits are correctly predicting a continued and substantial rise in reported profits, then I have to believe that that the equity market has some very substantial upside potential, as either of the trend lines in the last chart are also suggesting.


Benjamin Cole said...

More Asset Purchases Could Boost Economy, Bernanke Says By LUCA DI LEO And SUDEEP REDDY


PROVIDENCE, R.I.—Federal Reserve Chairman Ben Bernanke said Monday he believes further asset purchases by the central bank could help the economy, a signal that the Fed is likely to make the move if the economic outlook remains weak.
Speaking to college students, Mr. Bernanke said that even after the Fed cut short-term interest rates nearly to zero, it was able to lift the economy by buying $1.7 trillion of U.S. Treasury and mortgage-backed bonds in what he described as an "effective program."

"Additional purchases have the ability to ease financial conditions," he said. Fed officials at their policy meeting last month said they were prepared to take further steps to aid the recovery if the economy remains sluggish. The most likely move would be to buy more U.S. Treasurys.

Mr. Bernanke's comments follow indications from other Fed officials that the central bank is increasingly likely to move ahead with more asset purchases, perhaps at its early November meeting, barring a surprise improvement in economic data.

Maybe there will be an equities rally--if the Fed goes to sustained QE.

As this excellent post by Scott G. points out, the profits picture is not bad, and PE's perhaps a trifle low.

Scott Grannis said...

I would argue that the Fed's attempts at quantitative easing are hindering, rather than helping the recovery. It makes everyone nervous to see the Fed so nervous that it is willing to engage in another unprecedented round of debt monetization. I see little reason to think that QE2 will change anything for the better.

Benjamin Cole said...


Then why did Milton Friedman advise the Bank of Japan to engage in QE until they saw some real growth and inflation?

And really, Bernanke strikes me as a very smart, circumspect and cautious fellow, too much so. And even he is suggesting QE.

I am not a professional economist, so this argument, at a certain point, gets over my head. I have to defer to the Friedmans and Bernankes of the world. Perhaps I place too much faith in QE.

However, I disagree that the Fed will undercut the equities market by undertaking a steady $100 billion a month of QE--in contrast, I think the market will rally, if the program is properly explained (would that MF were here). Real estate would surge if there were solid prospects of growth and inflation ahead.

BTW, we may both get what we want soon: You get a R-Party Congress and I get QE.

We make see 15,000 on the Dow next year. And banks breathing a sig of relief as commercial properties rebound a bit.

John said...

It still remains to be seen what the chefs at the Fed are cooking...and I do think something is in the oven. I would have to bet the market will like a QE, at least at first.

I really think however it will accelerate the timetable for rate hikes if they continue with more stimulus. But we have a hurting economy and a slow recovery so it appears to me they will do more, and probably not long after the election they will present the pie. For better or for worse, that's how I see it right now.


Equities still look reasonably priced...but less so than late August. Good charts.

brodero said...

Trailing 12 month GAAP earnings for
the S&P 500 are expected to come in
for the third quarter at 69.71....
Moody's Baa yield is currently around 5.60%....which is a 17.85 P/E...but say the investing public
says " I am still skittish" I'll pay 17 times your confirmed trailing 12 month earnings ( which includes all the kitchen sink stuff) so 69.71 times 17 = 1185....

Charles said...

Corporations have huge amounts of cash on their balance sheets. This cash generates almost zero profit. Suppose we subtract the excess cash from stock prices and subtract the near zero profit on cash from income - as if corporations made a huge one time dividend. This would reduce reported P/E.

I believe stocks are reasonably priced given the alternatives.

randy said...


Here is a recent article about corporate cash - a lot of that cash has been acquired by issuing debt. Large corporations taking advantage of low rates, but not spending the money. Cash amounts to a little over 6% of total assets - somewhat less of net assets. Subtract out the offsetting debt, maybe not such a factor as it might seem. What is not encouraging is that the managers still see way too much slack to invest the cash. Anyway, the article is good background for your thought...


Public Library said...


This is a good illustration of how the Fed cannot trick people/businesses/cats/dogs into doing something they do not want to do. In fact, their efforts end up hurting most people while helping only the chosen few.

While those furthest from the inflation spigot get steamrolled, those closest to the spout lap up the benefits for next to nothing in return. All thanks to the Fed.

Buddy R Pacifico said...

The fact that corporations have lots of cash makes it compelling that equity prices are under-valued. As the worldwide economy improves these corps have the resources to grow their businesses without selling more equity.

Equitiies have an excellent chance at exceeding historical returns this decade -- especially S&P 500 because of global market capabilities.