Friday, May 31, 2013

Corporate profits are still strong, and markets are still skeptical

With yesterday's release of revisions to first quarter GDP we got a first look at corporate profits. Although after-tax profits slipped 2% from the prior quarter, they grew 6.1% over the past year and remain very high relative to nominal GDP. Despite the impressive performance of profits in recent years, the market remains skeptical about the future.

The two charts above compare the National Income and Product Accounts measure of after-tax corporate profits to nominal GDP over different time horizons. Although the growth of corporate profits has slowed in recent years, profits are at or near all-time high levels, both nominally and relative to GDP, with the latter comparison shown in the chart below. In the past 55 years we have never seen such a strong period of profits growth as we have in this recovery.  

The fact that corporate profits have tended to track nominal GDP over time is not unusual, but the degree to which profits have outperformed nominal GDP in recent years is exceptional. I've argued for a long time that the market looks at the first chart above and sees a compelling case for corporate profits to revert to their long-term mean (just above 6% of nominal GDP). That would of course imply either a huge decline in profits in the next few years, or an extended period of flat profits, and that helps explain why the market is reluctant to embrace equities. As the second chart above shows, equity flows have been strongly negative for the past six years, even as corporate profits have surged. In short, the market has been behaving as if it were highly skeptical of the durability of corporate profits.

The charts above represent two different ways to judge the valuation of the equity market, both using a ratio of equity prices to earnings. To construct these PE ratios I've used the S&P 500 index as the basis for the "P." In the first chart I've used the NIPA measure of after-tax corporate profits for the "E", and in the second chart I've used the traditional measure of 4-quarter trailing earnings per share for the "E." Both show similar patterns, and between the two of them they suggest that equity valuations are either very attractive (i.e., very low relative to the long-term average), or about fairly valued (i.e., approximately equal to their long-term average). One thing for sure: there is no sign here of any irrational exuberance. 

The above chart compares these two measures of corporate profits. Again, very similar, though NIPA profits have grown somewhat faster than S&P 500 earnings per share in the past 30 years and they have been less volatile. I note that NIPA profits tend to lead EPS, and one reason is that NIPA profits are quarterly annualized numbers whereas EPS are 4-quarter trailing profits, so NIPA profits are more contemporaneous. Another reason for the different levels of the two profits measures is that NIPA profits are based on IRS returns, and do not include things such as write-offs that can depress reported EPS. The recent growth of profits by either measure is modest, and it's tempting to think profits might "roll over" in the next year or two. That's what I think the market is already pricing in: a period of very weak growth or the possibility of a recession.

As a counterpoint to the view that profits are so high relative to GDP that they are very likely to revert to the mean, I offer the chart above. This shows that corporate profits are not very high at all when compared to global GDP. Global GDP has grown much faster than U.S. GDP in the past decade, and global sales have become an increasingly important source for the profits of U.S. corporations. So while profits look unsustainably high relative to U.S. GDP, it may simply be the case that, thanks to strong global growth which has greatly expanded the market for U.S.-based corporations, profits are going to move to a new high level relative to U.S. GDP—in other words, the mean is going to shift up permanently. The world has undergone fundamental and significant changes in the past decade, so U.S.-based metrics have become less relevant.

The chart above compares the earnings yield on the S&P 500 (the inverse of the PE ratio) to the real yield on 5-yr TIPS (inverted). The point here is to tie together the messages embedded in stock and bond prices. I think these two series track each other over time because they both reflect the market's confidence in the future health of the economy. When real yields were very high in the late 1990s, equity yields were very low; both were consistent with a market that had a high degree of confidence in the ability of the economy to grow and corporate profits to prosper. Currently, real yields are very low (though they have jumped quite a bit in the past two months) because the market worries that economic growth will be weak, and earnings yields are relatively high because the market worries that corporate profits growth will be disappointing. In short, both tell the same story: the market today is not optimistic at all about what the future holds in store for profits or for economic growth.

The chart above is another method of judging the valuation of equities. It subtracts the 10-yr Treasury yield from the earnings yield of the S&P 500. That gives you the extra yield that investors demand in order to hold equities instead of the safer 10-yr Treasury. The higher the equity risk premium, the riskier stocks are perceived to be. As the chart suggests, the market believes that equities are unusually risky at this time. That fits with my observations above that the market appears to be very worried that earnings are headed for an extended period of weakness.

Now, the market may well prove to be correct, and corporate profits and the economy could tank in the next few years. But to a great extent, that is what the market is priced to. If profits fail to tank and the economy fails to suffer another recession—even if the economy only manages to grow at 2% a year—the market may have to reprice upwards because the future will not turn out to be as bad as is currently expected. Avoiding a recession is all that matters. Long-time readers will know that this is the same story I've been telling for the past four years. The market has consistently underestimated the economy and corporate profits; the rally in equity prices has therefore been a reluctant rally, climbing walls of worry. I don't see a reason to think that anything has changed.


Stefano Bassi said...


It's the biggest market's bubble of the human history...made from the FED, BoE, BoJ, BCE etc etc

It's a NO SENSE analyze this NEW PARADIGM whith traditional tools&patterns...

Good Luck

steve said...

yah, i just don't think any of this matters. I've been in the financial service biz for over 30 yrs and have NEVER seen any consistent analysis that can effectively time the market. you will still be bullish when the market peaks and drops another 30-50%. I repeat; you are either a long term investor or not. everything else is mere banter.

Stefano Bassi said...

the only point of view of reality is only trading&Investment?
I think not...
the reality is more complex than buy or sell on the right timing...

John said...

Here is one long time reader who can attest to Scott's consistent good judgement of market valuations. I consider his opinions on the equity markets to be among the most valuable I follow.

William said...
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Michael Meyers said...

Scott, Thanks again for this series of charts. Your charts and analysis are best on the web. Regards, Michael

Mike Eliason said...

I wonder if the market is predicting a serious economic boom on the horizon. Businesses have been reluctant to invest those record profits in long term projects or significant numbers of new workers due to uncertainty. If that started to happen, GDP would probably start growing in the 3.5-4.5% range. There must come a point where you are looking at record profits and stop being scared of uncertainty about the future.

Benjamin Cole said...

Robust corporate profits are a good sign---another reason to keep as much of the GDP in the private sector as possible and shrink the federal welfare-warfare state in half.

The private sector does more for less continuously,; the public sector (including the Defense Department) does less for more continuously....

Benjamin Cole said...

BTW, the latest PCE deflator came in...the May price level was up 0.7 percent up, y-o-y.

This is an "expansive" Fed policy?

We get the lowest rates of inflation since Truman?

Seriously, if you think the Fed is "expansive" now, then you also think the Bank of Japan was "expansive" 1992 through 2012.

Yet Japan had sustained deflation through that period, and a rising yen. It was a very destructive period in Japan's history, especially to wealth.

The fact is, the Fed is tight, and has a monetary noose around the economy's neck.

William said...
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Nick Thorne said...

Scott, Thank you for helping us to hold the line.

theyenguy said...

You write, The market has consistently underestimated the economy and corporate profits; the rally in equity prices has therefore been a reluctant rally,
climbing walls of worry.

How true,

But then you write, I don't see a reason to think that anything has changed.

Everything changed this week.

Credit, that is trust, literally collapsed in May 2013, as is seen in the chart of Aggregate Credit, AGG, trading lower parabolically lower in value.

The great ZIRP unwind commenced the week ending May 31, 2013, as the monetary policies of the world central banks have finally resulted in turning “money good” investments bad, beginning first with the interest rate sensitive stocks, such as Electic Utililties, XLU, and Real Estate, IYR, and with Asian banking stocks, FEFN.

The debt laden Electric Utilities, XLU, which were carry trade darlings, were left abandoned on the dance floor, as investors rushed to the exit doors, on a rapidly steepening 10 30 US Sovereign Debt Yield Curve, $TNX:$TYX, seen in the chart of the Steepner ETF, STPP, steepening, on the sharp rise in the Interest Rate on the US Yen Year Note, ^TNX.

The interest rate sensitive, Mortgage REITS, REM, such as IVR, traded strongly lower in value. The pursuit of yield, which came with the blow off top in Liberalism’s grand finale rally, and which was in large part seigniorage, that is moneyness of the US Federal Reserve, exhausting, turning Retail REITS, O, NNN, GGP, Residential REITS, REZ, Small Cap Real Estate, ROOF, Premium REITS, KBWY, Real Estate, IYR, Global Real Estate, DRW, Industrial REITS, FNIO, and Chinese Real Estate, TAO, sharply lower.

High Dividend Paying Australia Dividends, AUSE, traded lower on the sharp trade lower in the Australia Dollar, FXA, as well as the Australia Bank, WBK. India Earnings, EPI, traded lower on the strong trade lower in the Inidan Rupe, ICN. Brazil Financials, BRAF, traded sharply lower on the trade lower in the Brazilian Real, BZF. Investors derisked out of Telecom Stocks, IST, Energy Partnerships, AMJ, EMLP, and Emerging Market Dividends, EDIV.

And the souring of investment trust, competitive currency devaluation is underway, with the Major world Currencies, DBV, and Emerging Market Currencies, CEW, trading strongly lower, terminating Nation Investment, EFA, and Small Cap Nation Investment, IFSM .

During May 2013, Jesus Christ, acting in the administrative plan of God for the fullness and completion of the age of Liberalism, Ephesians 1:10, produced Peak Democratic Freedom, Peak Nation State Sovereignty, Peak Seigniorage, as is seen in Peak Money, VT, Peak Currencies, DBV, CEW, Peak Credit, AGG, and Peak Clientelism and Dependency as well; all of which came through what Doug Noland terms wildcat finance, that is through speculative leveraged, toxic credit, carry trade investment, producing Peak Peace and Peak Prosperity, all based on ever increasing moral hazard, and coming with great libertine and ponerous living. And, He is now introducing the age of Authoritarianism.

Jesus Christ is pivoting the world from the old economy to the new economy; that from 1) from the paradigm of liberalism to the paradigm of authoritarianism, 2) from the fiat money system to the diktat money system, and 3) from the banker regime of US Dollar hegemony to the beast regime of regional governance, totalitarian collectivism, debt servitude and austerity, as foretold in Bible Prophecy of Revelation 13:1-4, also known as the ten toed kingdom of regional governance, as presented in Daniel 2:25-45.

William said...

Thank you, theyenguy for clarifying what happened in May. Now we know.

skydude said...

Great article.

What might be interesting to watch in the near future is inflation. If we avoid a recession (which appears likely) the pent up demand inside the economy will become unchained at some point.

With the monetary base sitting idle (for now) things could become interesting.

Thanks again for the insights!!

Scott Grannis said...

"If we avoid a recession (which appears likely) the pent up demand inside the economy will become unchained at some point."

Precisely. If there is pent-up demand, however, it is most likely in the form of cash and cash equivalents (e.g., bank savings accounts, bank reserves). If confidence returns the demand for this cash will decline, and people will attempt to reduce their holdings of cash. That will cause the velocity of money to increase, and that would fuel faster growth in nominal GDP.

Jake said...
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Jake said...
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McKibbinUSA said...

I'm not sure institutional investors are pessimistic per se, but households are certainly pessimistic in the extreme -- more at:

Households have yet to enjoy any demonstrable signs of an economic "recovery" in America -- this begs the question as to just what fiscal and/or monetary policy can do to bolster attitudes amongst households in America -- by the way, hoping or nagging households into optimism is not a method.

Gloeschi said...

The people demand CBP's spin on the ISM number

Junkyard_hawg1985 said...

The first quarter 2013 numbers for the Dow 30 were very good for most factors. TTM earnings per share jumped from $119.82 to $123.04 (new record). Net debt dropped from $541 billion to $489 billion. 12 of the 30 companies have increased dividends in the past 2 months.

The big downside from the past quarter is that TTM revenues for the Dow 30 FELL from $3.005 trillion to $2.971 trillion. Not only did revenues not keep up with inflation, they had an absolute drop. Revenues tend lead earnings. Hopefully, this turns around in the 2nd quarter. I'd hate for this to be the start of a trend.