Monday, May 2, 2011

Profits update: stocks remain attractive

According to Bloomberg's data on trailing earnings per share ($88.15 as of April '11), corporate profits have risen at a 20.9% annualized rate over the past six months, and 27% over the past 12 months. As the chart above shows, corporate profits by this measure continue to track the growth of corporate profits as measured in the National Income and Product Accounts, with the latter tending to be a leading indicator of the former.

Despite the impressive growth in profits, which show no sign yet of turning down, the market has been assigning a PE ratio of just over 15 to after-tax earnings for the first four months of the year. The current PE ratio is below the average (16.6) of the past 55 years, which is a sign that, at the very least, the market is conservatively priced. However, given that risk-free Treasury yields are very low from an historical perspective (giving today's 10-yr Treasury yield of 3.3% a PE ratio of 30), today's below-average PE ratios could be taken as a sign of substantial caution regarding the outlook for corporate profits.

This caution is confirmed by this next chart, which compares the earnings yield on stocks (currently 6.5%) to the yield on BAA corporate bonds (currently 5.9%). Equity owners normally should be willing to accept a lower yield than bond owners, since they can benefit from higher equity prices and higher top-line growth. Yet earnings yields have exceeded corporate bond yields for the past 12 months: a rare event, and a sign that the market believes that the outlook for earnings is very uncertain.

Full disclosure: I am long equities of all sorts at the time of this writing.


Benjamin Cole said...

A wonderful set of charts from Scott Grannis, something of a Hercules among economists for his heavy, yet data-rich blogging.

I gotta say, looks like bull markets ahead to me, and for a long time. Profits will be rising for a long time.

Only the unknown torpedo--a Long-Term Capital Management etc--can stop this bull. A global bull, I might add.

I think we have seen the first inning of this bull, and we have eight more to go. Which, unless you are a Los Angeles Dodgers fan, is a good thing.

randy said...

Thanks for that timely update. I almost posted to ask you to update that. The timing is good because today John Hussman notes in his weekly market update that stocks are overvalued as evidenced by a Shiller PE over 24. That of course is a stark comparison from the PE 15 data point in your argument. A good example of how what most think of as a relatively straightforward piece of information isn't so straightforward. The difference between the two factual values is that the Shiller is a 10 year average and therefore includes all the writeoffs from the crisis. The value presented in your post is current earnings ( I'm assuming ). There is a fairly good seeking alpha post about Shiller PE vs "standard?" PE found here.


Scott Grannis said...

I have said at least a few times, I think, that using 10-yr trailing earnings is a meaningless exercise. Much better to use current earnings. Both S&P reported earnings and NIPA profits are saying the same thing: stocks are far from being overvalued.

brodero said...

I love the Baa yield versus Earnings Yield me that is the most compelling...and receives very little focus...

Jason P. said...


Can you explain why the subsequent 7 to 10 year returns of the market so closely track the current Shiller PE or Hussman price/normalized earnings models?

In the aggregate, I have difficult time understanding your position that one forward operating earnings are more indicative of longer run future retune than other more cyclically adjusted measures of price to earnings.



brodero said...

Bottom Line about Hussman...great for bear markets...terrible for bull markets....

Jason P. said...


I was asking about valuation models that use historical, cyclically adjusted earnings and their efficacy in predicting subsequent longer range equity returns versus Scott's preference for using one year, forward earnings in his valuation determinations.

I wasn't asking about John Hussman's record over this latest two year rally off the '09 lows.

Does anyone have an opinion on this subject?

TradingStrategyLetter - Weekly Summary said...

It is amazing what a zero interest rate policy can do.

Scott Grannis said...

Re: Shiller PE model: I have several reasons for paying little attention to Shiller's model, which is based on 10-yr trailing earnings. For one, it is not flashing a clear warning sign today, being only slightly elevated. Two, I fail to see what earnings 10 years ago tells me about today. Three, the models I prefer use one-year trailing earnings (none of my charts or posts use forward earnings) or current earnings, as in the latest quarter corporate profit number from the National Income and Product Accounts. No model gives you precise recommendations with a great track record of success.

CDO Squared said...

The idea behind the 10 year average is to show some sort of normalized earnings, so at market peaks or bottoms you are not basing investment decisions on overly depressed or elevated earnings... I think Hussman and Shiller err in believing that a 10 year average is in fact a good or very good representation for normalized earnings. As Scott, points out, there really is no economic theory behind it.

Interestingly, an alternative valuation metric that Hussman abandoned was the price to peak earnings measure: (Current price against highest earnings measure over the past 10 years). This measure shows a much more attractively valued market compared to the 10yr PE and showed the market to be an epic buying opportunity at the March 2009 lows.

I think normalizing the treasury yield or Baa yield by showing the ten year average instead of the current yield is also useful... But as noted by Scott Grannis, none of these are precise indicators.

As this blog has noted repeatedly, if there is any type of continued economic recovery, risk assets are going to have big returns

Jason P. said...

The Shiller model - based on inflation adjusted average ten-year profits that attempt to encompass both expansions and recessions - is currently flashing levels that have been so rarely.  I think it sits at around 24 times.  

In addition, guys like Hussman - who uses a similar long range earnings power estimate - shows that his PE measure is highly correlated to subsequent 7 to 10 year prospective returns to investors.  His model forecasts returns in the 3-4% range over the next decade.

My trouble with reconciling your view - which uses 12 month trailing earnings or NIPA profits - is that it doesn't adjust for any cyclicality in earnings.   For example, do longer range negative adjustments for current record profit margins matter to you?  Do you think that economic cycles and reversions to the mean should affect the interpretation of valuation metrics?  

Looking at such a short term valuation metric of 12 mo trailing earnings seems too volatile to make any longer term valuation determinations.   For example, back in 2010, should one look at the depressed reported earnings for 2009 and determine that the market was expensive?