Tuesday, November 22, 2011

Corporate profits are still very strong

My wife thinks I'm insane to be pecking at the computer when a view like this is right outside our door, but I thought the news on corporate profits released today was worth a post.

Along with the revisions to Q3/11 GDP—which were not significant—we now have the first estimate of 3rd quarter corporate profits, and they continue to surprise on the upside. After-tax corporate profits increased 11.4% in the year ending Sep. '11. 

Relative to GDP, corporate profits are now at a new all-time high of 10.3%. This recovery may have been the most tepid on record, but the surge in corporate profits is unprecedented. This is grist for a lot of philosophizing, which I might attempt at a later date.

The chart above is my attempt to create a PE ratio using the S&P 500 index as a proxy for the value of all corporate equities, and the after-tax NIPA profits figure as the earnings. The level of the ratio is not as important as the relative changes that occur, since I'm using a normalized figure for the S&P 500 index. By this measure, equities have never been cheaper; the last time this PE ratio was this low was in the late 1970s and early 1980s, times which would have been fabulous buys with the benefit of hindsight. Extremely strong profits coupled with historically low PE ratios is a strong sign that investors are extraordinarily pessimistic about the future. This market is most definitely not suffering from an excess of enthusiasm. On the contrary, the pessimism is so thick you could cut it with a knife.

This chart compares NIPA profits to S&P 500 reported profits. Not surprisingly, both follow the same pattern over time, but NIPA profits appear to lead reported profits, and are also more stable. That would suggest we still have more good news to come for reported corporate earnings.

This chart compares total corporate profits to the profits of nonfinancial domestic corporate profits. Since both lines have tracked each other very well over long periods, there is no a priori reason to think that foreign-source profits today are unusually large, or that the profits of financial companies are out of line with historical experience.

All in all, some very welcome good news on profits, even if Q3/11 GDP was revised down a touch. Since the weather here in Maui is fabulous and the views are spectacular, it's time to go for a walk and enjoy the sights. With corporate profits still so strong, the world can't be a very dangerous place.

UPDATE: The fact that profits are up so much but equity prices are not is simply the market's way of saying that profits are likely to decline significantly in the future. In other words, one could argue that the market is priced to the expectation that profits will be mean-reverting in relation to GDP; instead of profits being 10% of GDP, the market expects profits to be 6% of GDP at some point in the future. Either nominal profits will decline or they will cease to grow as GDP expands. So if profits do fall or grow at a very slow rate in the years to come, that won't necessarily be bad for equity prices, because the market already expects that to happen. In a sense, profits must perform miserably just to validate the market's expectations. Profits could well prove to be mean-reverting, but if that occurs in an environment of relatively fast GDP growth and a benign fiscal and regulatory climate, then equity prices could advance significantly in the years to come.


Anonymous said...

"This is grist for a lot of philosophizing, which I might attempt at a later date."

Please do!

Frozen in the North said...

Yeah, sorry I must agree with your wife...you are nuts; go play outside stay away from your computer.

BTW thanks for the very interesting analysis. One question, since profits are so high (despite the cost of Obama's massive regulation push... sarcasm) is there room for considering that profits could return to the mean.

Just saying, profits are high, guidance for sales in Q4 seem disappointing, bit I'm a "damn bear" so I'm looking for some excuse to be wrong and to go long!

NormanB said...

Of course the last time the P/E ratio you have come up with was at this level was in the 1970's but at that time Profits/GDP was at its low. Using low P/E's at peak profits is investment folly.

Public Library said...

Doesn't this kind of shoot a hole in your philosophy about corporate tax rates and regulation in America? All we need is your other chart highlighting the boom in business investment and it's nail in coffin on those fantasies...

Scott Grannis said...

Today's profits are largely the result of yesterday's investments. One problem the economy faces today and going forward is that businesses are not investing much of their profits. Yes, capex is at a new high, but it hasn't increased much at all in the past decade, even though profits have more than doubled. High tax rates relative to other industrialized countries can help explain this. Corporations are still holding massive amounts of profits overseas, because they have already paid tax locally, but are extremely reluctant to get taxed at 35% again if they bring the money back. Lowering corporate tax rates would undoubtedly result in more investment, and that would lead to more growth and more jobs in the future.

The profits are there, just waiting to be deployed in new ventures and new jobs. The money needs to be unlocked by lowering tax rates.

Also, it is a truism that if you reduce the tax on something you will get more of it. Lower corporate taxes would result in more investment and more profits in the future.

Junkyard_hawg1985 said...

First, your wife is correct. Please let her know that we agree with her!

Next, the corporate profits in the NIPA accounts have both a strength and a weakness. The strength is that the definition of profit in the NIPA accounts have not changed much over time. This makes long term comparisons better than a simple P/E because the fdefinition of earnings has chnaged over time with accounting changes. The weakness is that most of the S&P 500 are now multinational corporations so corporate profits as a % of GDP is not a true measure. The corporate profits earned overseas boost the profit number without any corresponding GDP to go along with it. It makes the ratio look higher than it actually is. For stock market investing, this is good because we aren't out of the normal range for corporate profits as a % of production.

Anonymous said...

That first chart looks like a great leading indicator - and a long-leading one at that. Notice it peaks at least a year before a downturn materializes.

Anonymous said...

Actually, the second chart, though messier, also looks like a good long-leading indicator.

Benjamin Cole said...

Excellent set of charts and analysis by Scott Grannis.

But about corporate profits: Obama is killing Corporate America?

Judging from these charts (in a recession no less), we are being run by pro-business fascists.

Don't get me wrong---I am tickled pink by the rising corporate profit picture, even in tough times. This is a tribute to the private sector, which every year does more with less.

Our federal sector, largely agency spending out of control (see the Pentagon) does less with more every year.

I would like to see corporate taxes eliminated, perhaps replaced by gasoline taxes. Try getting that past rural Senators and Reps.

PS to Scott: Stay indoors by your computer. I'll go lounge on the beach with your beautiful wife.

Mark Holder said...

The different between the '70s and now are interest rates. Bank then the high rates competed against stocks and made them less appealing.

Now interest rates are so cheap that PEs should be double just to make the equation more of a debate. Stocks are clearly the cheapest asset around, but as 2000 showed us investors tend to want the most expensive investment as it has been popular for a while.

The equation could flip any day to where investors flood make into stocks and out of bonds.

marcusbalbus said...

where is nominal income for labor?

mmanagedaccounts said...

I rather think that investors have become extremely risk averse because of the tech bubble crash in 2000, 9/11 in 2001 and corporate malfeasance in 2002. Add to that Middle East tensions over the past decade, the housing and mortgage bubble crash in 2007-2008 and the uncertainty arising out of a huge growth in government. Now we can add Europe's debt and our debt. There's just no investor confidence in the future.

It all adds up to one very frightened little guy investor sentiment, and big guy caution.

I wish it were not that way and I am hoping we can replace our current leadership with a leader who gives us a hope we can believe in and realize.