Here are some charts that provide valuable perspective for some of the world's more important economic variables.
Crude oil prices have dropped by half in the past six months, so everyone tends to think that oil is suddenly very cheap. But as the chart above shows, the inflation-adjusted price of crude today is almost exactly equal to its average since 1970. Oil was really expensive six months ago, and now it's simply average. Fracking and horizontal drilling technology have erased the shortage of crude relative to global demand that persisted for most of the past decade, giving us reasonably-priced oil.
I note also that the recent decline, which is certainly huge, is actually smaller in magnitude than the decline that occurred in the first half of 1986. Back then, prices plunged from $28.75/bbl in early 1986 to (briefly) $8.60/bbl. Prices subsequently rebounded to close the year at $18/bbl. It didn't spell the end of the world then, and unlike the situation today, the plunge in oil prices in 1986 was accompanied by a sharply weaker dollar: the dollar peaked in early 1985 and by the end of 1986 had fallen by 30%.
The chart above shows the inflation-adjusted, trade-weighted value of the dollar as calculated by the Fed. Here again we see that the sharp increase in the dollar over the past six months has simply restored the dollar to its long-term average against both a broad basket of currencies and a relatively narrow basket of major currencies. The dollar is no longer cheap, but neither is it expensive.
Stocks have zoomed skywards in recent years, but the PE ratio of the S&P 500 today is only 10% above its 55-year average. That's not too scary, considering that after-tax corporate profits are at record highs both in nominal terms and relative to GDP (see chart below). Relative to GDP, profits are 70% above their long-term average.
The message of PE ratios is not that stocks are overvalued, it's that investors are still unwilling to believe that profits can maintain current levels. The earnings yield on stocks (the inverse of the PE ratio) is 5.5%. That's the expected return on an equity investment at current prices assuming no further gains in earnings. That the world is content to hold massive amounts of cash (e.g., $7.6 trillion in retail bank savings accounts) when the yield on equities is far higher than cash and 10-yr Treasury yields can only mean that earnings are perceived to be very much at risk. Put simply, there's still lots of pessimism out there.
As always, excellent blogging.
ReplyDeleteBut I gotta ask the question: Are these levels of corporate profits (the best ever, by any measure) the new normal?
Other variables may be near long-term norms, but corporate profits are at all-time records. Amercan companies are better-managed than ever. The information environment is rich.
But...competition. Should not such levels of profits attract competition?
This is a puzzler....
I'm wondering the same thing. What is driving these levels of profit?
ReplyDeleteAre the quality of earnings deteriorating? Company buying back shares, while increasing debt comes first to my mind.
ReplyDeleteShare buybacks are rampant but that does not artificially inflate aggregate profits. Debt is something to think about, however I think interest rates stay on trend and fall from here...I still wonder why profits are so high...these are the best times ever for Corporate America....
DeleteSeems to me that ZIRP has more to do with corporate profits these days than strong business performance. When you can refinance your debt using basically free money, and then use cash to buy your own stock and pump up the share price, profits are going to go up. "Less" debt on the books, and healthy returns thanks to leveraged stock purchases. (Ben Bernake called this creating a "wealth effect"...so we know it is being deliberately done.)
ReplyDeleteWe haven't yet reached "irrational exuberance" levels of investing...yet...but perhaps only because the more routine investors aren't buying it. Most everyone who wasn't bailed out by Congress/Bush/Obama lost their shirts as their 401K became a 201K or a 101K.
This is why the Fed keeps balking (for the 3rd year in a row) about fully exiting QE and starting to return to a normal interest rate policy. If they did that, the propped-up equity markets would tank as corporations/banks pull money out of stocks not wanting to pay the higher interest rates.
As for oil, the "average" crude oil price prior to the Arab oil embargo of the 1970's was well below $30/barrel. It is only in the age of the oil cartels that the new normal of about $50 has been reached. Call it the "oil price of totalitarianism".
Don't bet on these high profits being the new normal. These are market distortions caused by the Fed's ZIRP.
Tim-
DeleteBut share buybacks do not inflate aggregate corporate profits, which are at all-time records by any metric...
As for interest rates, the 30-year trend is down, and the 30-year experience if for economists to predict they will go up....
Maybe they will, but inflation is falling again, unit labor costs are deflating, and Bain & Co. says there are growing capital gluts...capital should be cheap, given supply and demand...
Could be we see even lower interest rates and even higher corporate profits in 2015...
I would recommend reading my post from last August on the subject of corporate profits:
ReplyDeletehttp://scottgrannis.blogspot.com/2014/08/what-happened-to-all-profits.html
Technology along with muted gains in employment costs are the reason corp profits are so high. companies are taking advantage of all the incredible gains in tech and they are going right to the bottom line-and this is also the reason that any discussion of average PE ratios and any other "market timing"
ReplyDeletenonsense id silly. it's not just different this time, it's different EVERY time.