Sunday, March 27, 2016

Profits are down; is that bad for stocks?

The recent release of the final estimate of Q4/15 GDP stats revealed that growth was stronger than had been previously estimated (1.4% now vs. 0.7% in the first estimate). It also brought us our first look at corporate profits for the quarter. After-tax profits were unquestionably weak, down 8% or so from the prior quarter, and down 12% from year-ago levels, after adjusting for inventory valuation and capital consumption allowances. (Without adjustments, after-tax corporate profits were down 8% for the quarter and 3.6% for the year.) As a percent of GDP, however, after-tax profits were still substantially above their long term average.

So, good news and bad news. Growth has slowed but the economy is not collapsing; profits are no longer growing and they are down on the margin. However, profits are still unusually strong relative to GDP. It is likely, of course, that profits have been depressed of late because of distress in the oil patch, but this doesn't change the more sobering fact that profits have not been growing much, if at all, for several years.

PE ratios today are somewhat above their long-term average, so considering that profits are flat to down would suggest that equity valuations today are unattractive. (Contrast this to a similar post I made in May, 2013, in which I argued that valuations were quite attractive.) But there are other considerations worth noting (see below), and on balance I think that, for long-term investors willing to overlook the current weakness, equities are still attractive.

The chart above compares the two measures of corporate profits that I am referring to in this post; one as calculated in the National Income and Products Accounts, and the other as reported by S&P 500 companies according to GAAP standards. A few years ago I discussed the difference between the two measures of profits here, concluding that of the two, the NIPA measure is probably the better one. Regardless, both have been flat to down of late.

The chart above shows the conventional PE ratio of the S&P 500 index as calculated by Bloomberg. Today's PE of 18.5 is about 10% above its long-term average of 16.7. Based on this simple fact, one could conclude that equities are somewhat unattractive, yet not nearly as unattractive as they were in the late 1990s.

The chart above calculates the PE ratio of the S&P 500 using corporate profits as calculated in the GDP stats as the "E", and normalizing the result to match the average of the conventional PE ratio. (It also assumes that the S&P 500 index is a decent proxy for the price of all corporate equities, which is quite defensible.) This arguably has several advantages relative to the conventional method of calculating PE ratios. Instead of using 12-month trailing earnings as in a conventional analysis, this method uses the annualized profits of the most recent quarter, thus giving us a more contemporaneous measure of multiples. Furthermore, NIPA profits are based on actual profits as reported to the IRS, which are quite unlikely to be overstated or otherwise distorted by accounting methods, or by equity buybacks. Interestingly, this method gives us a similar conclusion: PE ratios are somewhat higher today than their long-term average. In recent years this method has yielded PE ratios that were below average. Clearly, equities are no longer "cheap," but neither are they grossly overvalued.

The chart above compares NIPA corporate profits to nominal GDP. Both y-axes have a similar ratio scale, and are plotted in log fashion so that increases and decreases are representative of changes of similar magnitude.

The chart above shows the ratio of corporate profits to nominal GDP, using the data from the previous chart. Here we see how profits have been much higher relative to GDP in the past decade or so than they were in prior decades, and they remain substantially above their long-term average. This has led many skeptics to argue that profits will eventually mean-revert to a much lower level of GDP.

I've argued in a prior post that the unusually strong growth of profits in recent decades is most likely due to globalization, which has had the effect of significantly expanding the market for U.S. corporations. Apple can sell iPhones to billions of customers today, whereas that would have been impossible just a few decades ago. I would also note that when the after tax profits of U.S. corporations are compared to global GDP, they don't appear to be unusually high at all. That further suggests that profits relative to U.S. GDP needn't be mean-reverting. It could well be that profits have a higher floor, relative to GDP, than in the past, and that downside risks from here are not significant, so long as the global economy does not collapse.

The chart above shows the difference between the earnings yield (the inverse of the PE ratio) on the S&P 500 and the yield on 10-yr Treasuries. This represents the premium that investors demand in order to accept the risk of equities versus the security of Treasuries. The premium has not often been as high as it is today, and that's especially noteworthy. Consider: investors today are willing to pay more than $50 for a dollar's worth of 10-yr Treasury coupons, but only $18 or so for a dollar's worth of corporate earnings. That huge difference is symptomatic, I would argue, of a deep-seated risk aversion on the part of the world's investors.

Considering that the upside potential of equities is likely much greater than the upside potential of Treasuries (given the very low level of Treasury yields), it's interesting that the world's capital markets are apparently indifferent to earning less than 2% on bonds at a time when the earnings yield on equities (currently 5.4%) is considerably higher. This is another way of saying that the market has priced in very pessimistic assumptions for future growth and profits. All it takes to be bullish these days is to hold a less pessimistic view of the future than the market holds.

The chart above compares the level of the S&P 500 index to the ratio of the Vix Index to the 10-yr Treasury yield, the latter being a proxy for the market's level of fear, uncertainty, and doubt. For the past two years, rising levels of fear and uncertainty have corresponded reliably to declining equity values, and vice versa. This again confirms my view that equity prices currently are depressed because the market is still worried about the future.

The chart above illustrates the "Rule of 20," a valuation tool that is based on the belief that stocks are fairly valued if the trailing 12-month PE ratio on stocks equals 20 minus inflation. (The idea being that PE ratios should move inversely to levels of inflation; rising inflation drives interest rates and discount rates higher, thus depressing the present value of future earnings.) The Core Personal Consumption Deflator is currently about 1.7, which suggests a "fair value" PE ratio of 18.3, which is almost exactly equal to the current PE ratio of the S&P 500. Stocks by this measure appear fairly valued.

Conclusion:Stocks may be somewhat overvalued based on the level of PE ratios, but corporate profits remain robust and equities hold the promise of delivering substantially higher returns than risk-free alternatives. For investors that are willing to take the long view—that the U.S. economy is likely to continue to grow, albeit slowly—stocks are still attractive. 


Benjamin Cole said...

Great post.

Dividend stocks make good sense here.

It is well to remember that corporate profits as a fraction of GDP have doubled from the Ronald Reagan days and that GDP is much larger than then.

America needs better economic leadership, but on the other hand Corporate America has never done better. Good news.

McKibbinUSA said...

Neither of the Republican Presidential candidates are truly advocating for less regulation, less corporate taxation, and entitlement reform? Let's face it, Ted Cruz yearns for world war between the US and Islam, and Donald Trump is ready to open a global trade war with China, Mexico, and the Middle East. World wars are expensive (trillions upon trillions of dollars). Watch for the national debt to quadruple under either Ted Cruz or Donald Trump, while as many as a third of the US population dies in battle or as civilian refugees here in America.

The Cliff Claven of Finance said...

If you want to consider equity valuations, you should use more than one metric, not only the P/E Ratio.

The P/E Ratio has a bullish bias from unusually high profit margins (although they are declining).

There is no reason to believe a regression to the mean corporate profit margin will never again happen.

Data below from the Fed's Z.1 Flow of Funds strongly suggests stocks and bonds are extremely overvalued, not slightly overvalued::

Equities ended 2015 at 199% of GDP -- that is a very high valuation.
Warren Buffett once said this was his favorite valuation metric.

vs. 44% to begin the 1980s,
67% to begin the 1990s, and
200% to end the 1990s (Bubble Year 1999).

Combining Debt and Equity Securities,
Total Securities ended 2015 at 415% of GDP -- that is a very high valuation, and probably a record high.

vs. 366% in 2007,
109% to begin the 1980s,
178% to begin the 1990s, and
341% to end the 1990s.

The S&P 500 hit 2000 on August 26, 2014

The S&P 500 is trading at 2037 today, up less than 2% in the past 19 months.

If stocks are highly valued relative to GDP, and not in a rising trend for the past 19 months,
then it is a bad time to own stocks, based on stock market history.

The right time to own stocks is when they are cheap relative to GDP, and in a rising trend.

Doug MacGibbon said...

Answering comment 2:

"Neither of the Republican Presidential candidates are truly advocating for less regulation, less corporate taxation..."

- That isn't right. Cruz would repeal "every word" of Obamacare, as just one example, and both would drastically reform corporate taxation.

"Ted Cruz yearns for world war between the US and Islam..."

- That isn't right either. "Utterly destroy ISIS" doesn't leave much left to fight in a word war, and his war isn't against Islam. The ISIS threat grew to world war level when we weren't actively opposing them.

Back to the substance of the original post, "...growth was stronger than had been previously estimated (1.4% now vs. 0.7% in the first estimate)":

With due respect, there must be a term milder than 'stronger growth' to describe an economy expanding at a one percent rate. Maybe: US 'stagnation' looks to be better than expected in the 2nd quarter...

Scott Grannis said...

Doug: "less anemic" might be a better term to describe the upward revision to fourth quarter growth.

Doug MacGibbon said...

Thanks Scott. )

Gordon H. Grannis, DC said...

The chart showing Corporate Profits compared to GDP looks to me like we are nearly entering recessionary territory, based on similar patterns of rising then falling profits, just preceding the recessions of 2001and 2008. Simplistic?

Scott Grannis said...

We saw a similar dip in profits in 1987 following the oil price collapse of 1986. It proved only temporary and a recession didn't come until 1990. This could be another episode like that one. Plus, corporate profits today are still very strong from an historical perspective and monetary policy is far from being a threat to anyone.