Thursday, August 29, 2013

Corporate profits continue strong

Today's first revision to Q2/13 GDP growth (which was revised up from 1.7% to 2.5%) brought with it the first look at corporate profits for the quarter, and the news was excellent. After-tax corporate profits rose to a new all-time of $1.68 trillion, up 7% from a year ago. This is actually within the realm of astonishing if one considers that this measure of profits (arguably the best measure of "true" or economic profits) has increased 218% since the first quarter of 2000 (when the S&P 500 hit its peak for the year), yet the S&P 500 is up only 7.5% since then. With the benefit of hindsight we know that stocks were grievously overvalued in 2000—but that can hardly be the case today.

Note how strong corporate profits have been since 2000, despite the current sluggish recovery (actually the weakest recovery in history).

The chart above provides a long-term perspective on how corporate profits behave relative to nominal GDP.

Relative to nominal GDP, corporate profits today are just shy of an all-time high.

Using the methodology explained in my post last week, the chart above shows the PE ratio of the stock market using the NIPA measure of after-tax corporate profits instead of trailing 12-month earnings. This suggests that stocks currently are trading about 25% below their historical average PE. This is also astonishing since PE ratios tend to track interest rates inversely (i.e., PE ratios tend to be low when market interest rates are high, and vice versa). 10-yr Treasury yields are still extremely low from an historical perspective, yet PE ratios are quite low from the same perspective. This suggests that the market has hardly any confidence in the ability of corporate profits to maintain current levels. Instead, it seems like the market is priced to the expectation that corporate profits will "mean revert" to their long-term average of 6-6.5% of GDP.

But as I've argued before, it is not necessarily the case that corporate profits have to, or are likely to, revert to some historical mean relative to GDP. U.S. corporations are increasingly operating in a rapidly-expanding global economy and marketplace. As the chart above suggests, corporate profits relative to global GDP are still fairly close to their long-term average. Thus there may be little reason to think that profits need to decline significantly or that they are at unsustainably high levels today.

NIPA profits and reported earnings tend to track each other over time, with NIPA profits tending to lead trailing earnings. This suggests that reported earnings are likely to continue to grow.

At the very least, the news on corporate profits provides solid support to the current level of equity valuations. Viewed from an optimistic perspective, stocks would appear to have lots more upside potential and could be considered significantly undervalued.


McKibbinUSA said...

What needs to be explained is how and why rising corporate profits are apparently correlated with declining national prosperity as measured by long-term real working wages, real home values, and the employment to population ratio -- we might call that the "Scott paradox"...

McKibbinUSA said...

PS: Or perhaps, the "Calafia Beach Paradox"..

Scott Grannis said...

Strong corporate profits show that the private sector is doing very well, and is very productive. The drag on overall growth comes from our bloated and inefficient public sector.

McKibbinUSA said...


Kurt said...

I read a piece in the WSJ recently where the author claimed that much of the profitability of corporations in the past ... decade? or two? ... have come from lowering labor costs, such as by outsourcing to low-wage countries like China. The author was concerned that corporations have been putting less into R&D and less into capital upgrades (newer technology) than in the historic past. He thought that the gains from outsourcing and the like are unsustainable -- e.g. labor costs in China are rising now -- and corporations are going to have to pony up sooner or later.

Any reactions to that piece, Scott?

Benjamin Cole said...

Like Scott Grannis, I am pleasantly surprised at the very healthy level of corporate profits---and this, during a business-unfriendly Obama Administration and so-so (at best) economy.

To me, that suggests these profits are structural---they are not going to go away on some small changes.

Jeez, would would happen if we got a pro-business administration in there and a good economy?

(BTW, I just wish I could vote for a pro-business party not run by warmongers and big spenders).

One quibble: I am not sure I would count financial sector profits as "profits." The financial sector is there to shrewdly allocate capital, but when it becomes a profit-sector in its own right, it is then trending towards parasite status.

Hans said...

How much of this Corp growth rate is due to operations overseas?

The profits will not come back to the motherland and thence be of little value...

Junkyard_hawg1985 said...

Several years ago DuPont had a CEO who stated our long term goal was to grow revenue by 6% per year and earnings by 10% per year. All of us nerdy engineers whipped out the calculators to figure out how long it would take for our earnings to exceed our revenues. I tell this story because the Dow 30 EPS hit a record for earnings last quarter. The problem is that total revenues (ttm) for the Dow 30 fell last quarter for the second quarter in a row. That is not a good sign for future earnings.

Pragmatic Investor said...

It's misleading and incorrect to compare US corporate earnings to world GDPs. Sure, US companies are earning more from overseas. But foreign companies are also earning more in the US and contributing more to US GDP. The net effect is probably small.

Plus, the world GDP is growing a lot faster than US GDP thanks to emerging markets. It's naive to assume US companies earn the same share of profits in the US as in emerging countries.

If you want to show whether stocks are overvalued, you should either compare US stocks to US GDP or world stocks to world GDP. Comparing US stocks to world GDP is comparing apple to orange.

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