Thursday, December 5, 2013

Corporate profits just keep on increasing

Today's revision to Q3/13 GDP gives us our first look at corporate profits for the quarter, and they just keep on growing. Nominal after-tax profits are at a new all-time high, and have risen almost 9% in the past year. This is very impressive no matter how you look at it.

The two charts above show after-tax corporate profits and nominal GDP; the first chart takes the long view, while the second chart zooms in on the past quarter century. The y-axes of both graphs have similar ranges, so it should be apparent that corporate profits have risen at a much faster pace than nominal GDP both in the current recovery and over the past two decades. 

The chart above shows after-tax corporate profits as a % of nominal GDP. Profits are very close to an all-time high on this basis, and significantly above where they have been over the past 55 years. It's been my view for the past several years that the market looks at this chart and sees a mean-reverting phenomenon, and thus expects profits to revert to 6-7% of GDP over the foreseeable future. This implies that the market has very little confidence that profits will continue to increase, and is very worried that profits could suffer a significant decline, both nominally and relative to GDP, in coming years. That's why PE multiples are only average despite the fact that profits are at record levels. (Last August I explained this in more detail.)

In effect, the market is priced to a significant deterioration in the profits outlook. Yet profits continue to defy their presumed mean-reversion tendency and continue to increase. Profits will undoubtedly decline when we suffer the next recession, but that might be years away. Worrying about an imminent recession is characteristic of this entire recovery, as I explained yesterday ("The most risk-averse recovery ever"). But so far, the pessimists have been missing out on a fabulous equity rally.

The chart above shows the PE ratio of the S&P 500 index using NIPA profits (the BLS's calculation of total economic after-tax corporate profits). I've normalized the S&P 500 index so that the average PE ratio using this method is similar to the long-term average PE ratio of the index using reported corporate profits. Here we see that PE multiples are significantly below their long-term average, whereas the reported PE of the S&P 500 is about average (see chart below). I explained the reason for the differences in these two PE ratios, and their rationales, here.

In short, this market continues to be very skeptical of the future. Very risk averse.


steve said...

a cursory look at your charts strongly suggests that profits as a % of gdp have gotten way ahead of themselves and will revert as they did in '99 and '08. consider the length and size of this bull and that tapering is surely imminent and
sentiment is at best complacent and you have a very nice recipe for the next bear. not to mention that the fed has artificially kept rates way to low. the fed has a 100% track record at *&^%ing up the markets and i see no reason that this time is any different.

Scott Grannis said...

As I try to point out in my post, what "steve" describes is what I believe the market is priced to. The market has been worrying about a profits mean reversion for years, but it hasn't come. Arguably, since the market fears substantial weakness in profits, the reality of a profits decline might not cause the market to decline significantly.

I note that profits declined well in advance of the equity peak in 2000, and they declined well in advance of the Great Recession and the equity peak of late 2007.

William said...

Schaeffer's Investors Intelligence

This is a weekly survey of investment advisers' sentiment. At the October 2007 market top the Bulls were 62.0%. This week the Bulls are 57% and the Bull / Bear Ratio is a rarely seen 3.99



Benjamin Cole said...

The private sector does more for less continuously...despite some recent naysaying about the speed of innovation, I suspect the private sector is still using iPhones, iPads, the Internet and other technologies to improve productivity...

More is dropping to the bottom line...

Wages/compensation well under control....

Look for several years of this, as long as the economy can expand...

Hans said...

To want degree has free money (low interest rates) meant to corporations bottom line?

After all, the general economy is sub-par at best..

There must be a reason as to why companies are generating such a great deal of money; it certainly is not a booming growth..

Hans said...

Ben Jamin, you may have a point on the productivity side of things.