Thursday, May 31, 2012

Corporate profits continue to impress

With today's release of revised first quarter GDP statistics comes the first estimate of corporate profits for the first quarter. I've been highlighting this measure of corporate profits, which comes from the National Income and Product Accounts (NIPA), and adjusts for inventory valuation and capital consumption allowances, for quite some time, since it is 1) based on corporate profits as reported to the IRS, not on profits as reported according GAAP rules (and thus provides what might be termed "true economic profits"), 2) it uses a consistent methodology for measuring corporate profits going back to 1958, and 3) it is an annualized and seasonally adjusted number that arguably provides a more current estimate of profits than the traditional one-year trailing measure of profits that is used to calculate PE ratios. (HT to Art Laffer, who has been making these arguments for as long as I can remember.) 

As the first two charts show, total after-tax, adjusted corporate profits in the first quarter fell 4% from the previous quarter, from $1.576 trillion to $1.511 trillion, but they remain extraordinarily strong relative to nominal GDP. First quarter profits were up 4% from a year ago.

Using the NIPA measure of corporate profits as the "E" in P/E ratios, and using a normalized S&P 500 index as a proxy for the "P" of all corporate equities, I derive an alternative measure of the P/E ratio for the entire corporate sector of the U.S. economy. According to this measure of equity valuation, equities are almost as cheap as they have ever been. Another way to appreciate how cheap equities are is to consider that over the past 20 years, corporate profits have increased 340%, while the S&P 500 index has increased only 250%. Since the end of 2008, by which time corporate profits had collapsed, through the end of this year's first quarter, corporate profits doubled, but the S&P 500 only rose 60%. Clearly, prices have not kept up with the growth of profits.

Even using the standard methodology (dividing the S&P 500 index by one-year trailing earnings), equities look to be relatively cheap: today's PE ratio is 13.2, which is 15% less than they average of the past 50 years.

Although total corporate profits fell 4% in the first quarter, the profits of nonfinancial domestic corporations surged to a new high; thus, the weakness in total profits came mainly from the financial and international sectors, and the strength came from the domestic operations of non financial corporations.

Once again I feature this chart, which I think is very important to bear in mind. Many will argue that since corporate profits are at extremely high levels relative to GDP, they are very likely to mean-revert to their long-term average at some point. That would involve an extended period of very weak or negative growth in profits, and that is enough to given any equity bull nightmares. But in a sense a big drop in profits has already been priced in, because current PE ratios today are substantially below average; it's as if the market already expects to see a mean reversion in profits.

As the above chart suggests, corporate profits relative to world GDP are not unusually high at all, and any mean reversion here would be relatively minor. I think there is a strong case to be made that it no longer makes sense to compare corporate profits to U.S. GDP, since the U.S. economy is much more integrated into global commerce than ever before. One proof of that is in the chart below; in the past 30 years, U.S. exports of goods and services have grown 2 and a half times faster than GDP. More and more companies are able to market their products all over the globe, and the global market (e.g., India, China) has grown by leaps and bounds in the past decade. More and more companies are finding that the market for their products and services has grown by much more than the U.S. market, so it is not surprising that profits have grown far more than nominal GDP. Going forward, corporate profits are likely to average much more than 6% of GDP.

2 comments: said...

Continuing to buy equities on down days all along.

Productivity gains mean more is being produced with less labor, or lower cost labor.

As the unemployed come back on (private) payrolls, we will continue so see equities rally.

GDP lags, but a greater percentage of S&P 500 corporate profits are earned from overseas operation.

All this negativity is keeping a lid on the stock prices. Good for buying.

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