Friday, August 26, 2011

Corporate profits are fantastic—what's wrong with equity prices?

Today's revision to second quarter GDP brought with it our first look at corporate profits, and they were once again very strong, if not fairly spectacular. Not only were after-tax profits up over 9% relative to a year ago, corporate profits are now at an all-time record high of 10.1% relative to GDP. We've never seen anything like this.

So the question that absolutely begs to be answered is this: Why haven't equity prices kept pace with the huge increase in corporate profits? After-tax corporate profits averaged $554 billion in 2000, and the S&P 500 index averaged 1423 that year. Now corporate profits have soared by 173%, but equity prices have fallen by over 17%. Hold on, you say, it's obvious that equity prices were in a bubble in 2000. Ok, so let's go back to 1995 for purposes of comparison. In 1995 the PE ratio of the S&P 500 was 16.5, about equal to its long-term average, and the index averaged about 550 that year while after-tax corporate profits averaged about $500 billion. So in the past 16 years, corporate profits have tripled, while the S&P 500 has only slightly more than doubled. There's no getting around the fact that equity prices have seriously lagged the performance of corporate profits.

And if you consider that interest rates have collapsed in the past 16 years (the 10-yr Treasury yield averaged 6.5% in 1995, and now it stands at 2.2%), then the lagging performance of equities becomes even more amazing. If the value of equities is a function of the discounted present value of future after-tax profits, then a huge decline in the discount rate ought to result in at least some rise in PE multiples, shouldn't it? But the PE of the S&P 500 today is less than 13, about 30% less than it was in 1995.

I've done this analysis every quarter for the past several years, and each time I conclude that the only logical explanation for why stocks are lagging profits is that the market expects a) interest rates to rise and/or b) profits to decline in future years. So far, neither have happened; in fact, interest rates have fallen and profits have continued to rise. Maybe the market has just been looking way ahead to events that have not yet happened, or maybe the market is just way too pessimistic. But one thing is clear: it's difficult if not impossible to find even a shred of optimism in today's equity valuations.

Here's another way of looking at this. The chart above represents the PE ratio of all corporate equities, using a normalized S&P 500 index as a proxy for the "P" and the National Income and Product Accounts tally of after-tax corporate profits as the "E." PE ratios by this measure are about 10, significantly below their long-term average of 15.6. Stocks are very cheap by historical standards, and the last time they were this cheap, in the late 1970s and early 1980s, was an excellent time to invest from a long-term investor's perspective. Skeptics would counter by saying that this time is different, because 1) politicians are incapable of spending restraint, so taxes are going to rise significantly, 2) the economy is going to be miserable for the foreseeable future, pushing profits way down, and 3) the Fed's super-accommodative monetary policy is going to push inflation and interest rates much higher. Maybe so, but that's about what it would take to justify the current level of prices.

Bottom line: you have to be very pessimistic about the future in order to not like equity valuations today.


seekingtraceevidence said...

Great comment on valuation. I find that the Real GDP trend(3.04% past 25yrs) combined with the 12mo Trimmed Mean PCE(Dallas Fed core inflation measure)is the quasi-Holy Grail for market capitalization rate on the long term SP500 mean earnings trend line which is $71.50 today or when capitalized 1560 for the SP500. The market does not react to the under/over valuation due to market psychology, but eventually they converge. When undervalued like today the market eventually catches up and exceeds the fair valuation level. 2000 and 2007 were each 100% over-valued.
Patience should eventually be quite rewarding.

FriendFromTheNorth said...


Not related to this topic, but I wanted to thank you for your excellent blog.

I was once a Keynesian (I can hear the hiss and boos now), but was disillusioned with the failure of the Obama stimulus. After reading your blog, I'm now an avid supply sider.

Just wanted to thank you for your great blog, detailed analyis, and advice. Wish you the best.

John said...

The investing public has been driven out of equities by the volatility. What's left are traders gaming a system with increasingly sophisticated platforms and products designed to enhance price changes, institutions employing machine gun buying and selling to capture pennies per share movements, rumor mongering over 'black swan' events with little more than opinions backing the fear selling, and an SEC in bed with the perpetrators because it enhances revenue for the government (more trades, more income, more taxes). The simple investor has correctly surmised the game is rigged, and that if he plays, he is swimming with sharks. To earn the high returns possible in equity investing the investor must suffer as much as 50% volatility to his principle. Its no wonder he sits it out, regardless of how many times he hears how cheap stocks are or how good profits are.

Now these are just my observations and opinion. I am an equity investor and have been for a longer time than some reading this have been alive. I remember the times when machines were used to get quotes and you had to call someone to place an order. The game has changed massively, and IMHO not much of it is for the better.

I am still an optimist. I believe that pessimism in the markets is so deep and pervasive that weak holders are long gone. Institutions have piled into the bond market to escape the volatility and capture the appreciation in a popular asset class. The bond bull is old and will IMO die soon. When it does, institutions with required rates of return will exit in mass. The money will have to go somewhere. Commodities have been bid up and real estate is a popped bubble. They will nevertheless attract their share of the money. Ironicly, it is equities that IMO offer the highest returns. Over half the S&P 500 yields more than the 10 yr UST bond...and those yields can go higher over time. Pension fund managers, again, IMO, will find the required yields in the Exxons, Procter & Gambles, Coca Colas, etc. It will be these institutions that will become the new owners of corporate America, and the money will come from the bond markets.

Many will disagree with this thesis, and with good reasons. However the best investments are often friendless at big turning points. At almost this exact time last year pessimism was deep but equity prices embarked on a huge rally that carried into 2011. Perhaps we are on the cusp of a similar occurance.

Benjamin Cole said...

Investor confidence.

Bernanke said in his Jackson Hole speech that our national budget process is the Gong Show, and so people lose faith in the USA. Add to that a major presidential candidate (Perry) suggesting we execute our Federal Reserve Board chairman.

If you were a foreigner, would this theater of the jackanapes encourage you to buy American? Foreigners are important buyers of US securities.

And who knows if another Long-Term Capital Management has its torpedoes ready?

May take a new President. who is a sensible sort of guy, to restore investor confidence.

Good luck.

Benjamin Cole said...

PS I like dividend stocks that can almost prove they will maintain their dividends.

brodero said...

The corporate profits numbers are
truly stinning today and lost in
the news...look at the S&P 600
versus Corporate profits ( the national accounts number)over the last 60 years...stocks are undervalued

Junkyard_hawg1985 said...

I think one of the key reasons the data looks a little different is the measuring system. In 2Q11 (Table 12 of today's release), corporations earned a net of $437.9 billion in profits overseas. This skews the number relative to GDP as overseas profits help U.S. companies, but will not be reflected in the GDP results. If you remove the money from overseas sources, the data will look more like historical averages.

septizoniom said...

could a and b not define the universe of answers? perhaps its c: profits being high is not stictly correlated to equity prices; equity prices may discount other factors as well.

Comicnose said...

You wrote:
The chart above represents the PE ratio of all corporate equities, using a normalized S&P 500 index as a proxy for the "P" and the National Income and Product Accounts tally of after-tax corporate profits as the "E."

What is a "normalized S&P 500 index" in this context? Is it some average value?

Thank you. said...

Scott. a couple of things

Warren said at beginning of 00's stocks would return 6 percent annually over the next twenty years. 15.6x is 6.4% earnings yield.

If the 15.6 is the average over time as you say, then there are periods above and below the average. From '82 to '00 the annual return for equities was in excess of 15 percent per annum.

This period is like 1966-82. It might be useful to see what the normalized p.e. for the S&P was during the flat '66 to '82 period.

All in all, the current political situation is keeping a lid on market enthusiasm, making for better prices in which to accumulate shares than during a period of market 'irrational exuberance.

Pragmatic Investor said...

Stocks are a claim on a very LONG TERM stream of cash flows. Corporate profits, just like all businesses, go through up and down cycles. Therefore, using P/E ratios based on one year profits, especially when margins are peaking, is pretty useless. That's why the Shiller P/E based on 10 year earnings is so much better with superior predicting power. Besides, the past decade has been the most overvalued period in the history. Including periods prior to 1960 will significantly lower the long term average P/E ratio.

Perhaps if you are willing to listen to other people's different opinions and start to use real S&P earnings that go back to the 1920's, not some so-called NIPA earnings, you will not be so confused.

William said...

In my 70 year old opinion, John is spot one. I have been making the same argument for the past two years. The present reminds me of the mid to late 1970's after the horrific bear market of 1972 to 1974.

About 1976 Newsweek or Time featured a classic cover story entitled: "The End of Equities". It was a buy signal for the 4th quarter of the 20th Century.

In my view, we are in a similar disheartened period where investors are disgusted with equities. We have another few years of bumpy equity prices as in the late 1970s and early 1980s as all this information is digested. But the horrific bond bear market of this same period did indeed force investors to shift slowly but surely to equities.

John said...

"The investing public has been driven out of equities by the volatility. What's left are traders gaming a system with increasingly sophisticated platforms"

John's right. The game has changed and the small investor is in a bind.

Hedge funds and HFT have wreaked havoc on the markets. They don't think about the future; they buy and sell stocks in seconds.

William said... said..."Scott. a couple of things

Warren {Buffet} said at beginning of 00's stocks would return 6 percent annually over the next twenty years."

Actually Buffet said 10 years. In the 3rd week of October 2008 Warren wrote an Op Ed in the WSJ stating that his personal investments had been in US Treasures but with the sharp stock market decline he was mostly in equities and "if the market declined further, he would soon be 100% in equities".

In November 2009 when his Berkshire purchased Burlington Northern Santa Fe, at a 31% premium Buffet commented: "Berkshire's $34 billion investment in BNSF is a huge bet on that company, CEO Matt Rose and his team, and the railroad industry. Most important of all, however, it's an all-in wager on the economic future of the United States. I love these bets".

Last week Buffet was quoted again saying that Berkshire was making some of the largest stock purchases that it had ever made in the open market. Buffet said: "I love buying bargains."

mmanagedaccounts said...

It was in 1995 I was having a telephone conversation with Robert Goodman, Chief Economist at Putnam Investments in Boston. "How much longer will this strong economic growth last," I asked him. His reply, "It will last as long as the American people are more converned with the growth of wealth than they are with the distribution of that wealth."

John said...


"How much longer will this strong economic growth last," I asked him. His reply, "It will last as long as the American people are more converned with the growth of wealth than they are with the distribution of that wealth."

I guarantee you, the vast majority of American people, the non-managerial private sector workers that make up about 80% of the workforce, are very much aware of a 30-year upward shift in distribution. They don't like it, but they don't know what to do about it.

They worry if they "piss off the boss," they'll end up out of a job, crappy as it may be. They don't feel like anyone, not business, not government, is on their side.

Scott Grannis said...

Re: "normalized S&P 500" It's simply the S&P 500 index multiplied by a number that best aligns the result with capitalized economic profits over the years. The factor I'm using is approximately 12.

GestaltU said...

It seems to me that the answer to the TTM PE conundrum is fairly obvious. Corporate profit margins, and the share of capital relative to labour, are both at record highs. Unfortunately for stock market investors, these two ratios are the most mean-reverting ratios in finance. Thus, profit margins are peaking (or have peaked), and are set to decline for the next 10 or 15 years.

Contemporaneous profit margins are a function of extremely cheap money being leveraged by corporate treasuries to invest in capital intensive projects. That is, companies are purchasing expensive equipment from other companies to enable them to do more with less.

While these investments will reap benefits once end demand resurfaces, at the moment companies are scaling up for demand that does not exist.

This is the most business friendly environment that global businesses have ever experienced; investors are preparing for a long-term reversion to the mean. said...

William, just to be clear to WHICH WEB quote I was referring...Carol Loomis Buffett Fortune interview.

"Let me summarize what I've been saying about the stock market: I think it's very hard to come up with a persuasive case that equities will over the next 17 years perform anything like--anything like--they've performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate--repeat, aggregate--would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that's 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more."

NormanB said...

These 19 comments are the best I have ever read, the best. Mr. Grannis, you have one hell of a following here.

Rick said...

Perhaps the largest increases in corporate profits are occurring in publicly traded corporations that are not included in the S&P 500 and in privately held corporations; e.g., Facebook. Early 2011 forecasts for S&P profits were about $95 EPS. Today's PE ratio of ~12X for the S&P 500 reflects a reasonable discount of a likely decline in those profits due to weak 2H guidance from about 20-30% of the components of the index.

Junkyard_hawg1985 said...

There is also the investing trends at play here. The market comes and goes in cycles with the P/E expanding and contracting depending upon market sentiment. Crestmont Research has put together what I consider the single best stock chart of all time. It has all of the stock returns (including dividends) since 1900 on a single matrix in real terms and it is well color coded so you can see the trends. The matrix shows any multi-year return you want to see as well. Notice that there is a 20-year line on the chart. The real 20-year return has turned negative on 3 occasions (1921, 1949, and 1982). All of these were great buying opportunities and the dividend yield was 7%, 7%, and 6& respectively. The current dividend yield on the Dow is around 3% so there is still some downside potential in the market. This downside is not based on fundamentals, but based on investing herd mentality. said...

Mr. Grannis, there is a Value Line long term chart (I have a copy of it up through 2005, or so), that shows annual performance in a number of metrics, bond yields, dividend yields, inflation, Dow Jones average, etc.). It is along the lines of Junkyard_hawg1985's link, kind of an 'all inclusive' chart/graph. I'm sure with your contacts inside finance and economics, you might be able to snag the most current update of it and post. If you'll provide me a way to email you, I'll send you my outdated copy.