Friday, June 29, 2018

Corporate profits are huge

I've had many posts over the years highlighting the strength of corporate profits. This post adds to the list, but it is notable for being the first to highlight the impact of Trump's tax reform on after-tax corporate profits. As I mentioned last December, Trump's reduction in corporate income taxes translated (via math) into a 20% one-time boost to the after-tax profits of a given level of nominal profits. According to yesterday's release of revised GDP stats for the first quarter, after-tax corporate profits (adjusted for inventory valuation and capital consumption allowances, a measure Art Laffer convinced me was the best, being based not on GAAP profits but on true economic profits using IRS filings) reached a record $1.92 trillion (annualized), up almost 17% from a year ago. That's equal to 9.6% of GDP, a level that has been exceeded in only 4 quarters in our nation's recorded history. After-tax profits are likely to move higher still, once the full impact of lower corporate income tax rates filters through to the data as the year advances.

Corporate profits paint an attractive picture for today's investors, since equity valuations seem only moderately higher than their long-term averages, even as profits reach very high levels relative to GDP, as I discuss below.

 Chart #1

Chart #1 compares after-tax corporate profits to nominal GDP. Over the past three decades, profits have increased at a much faster pace than nominal GDP. (Note that the two y-axes have a similar ratio from bottom to top, and both are semi-log.)

 Chart #2

Chart #2 shows the same measure of profits, but as a percent of nominal GDP. Note that for many decades prior to the current business cycle expansion, the ratio of profits to GDP averaged just over 6%. Five years ago I thought that the market was skeptical that profits would remain at such "elevated" levels and would inevitably revert to their 6% of GDP mean. Yet profits just get stronger. If there has been any long-term theme in my posts since late 2008, it's that the future ends up being better than the market expected, even though the economy's growth rate has been sub-par. The market has held relatively dismal expectations for many years, and has been pleasantly surprised. That's why equity prices have been moving higher.

 Chart #3

Chart #3 shows the traditional measure of stock market valuation: the ratio of trailing 12-month after-tax profits per share to share price (using reported earnings from continuing operations). Currently, the PE ratio of the S&P 500 is 20.9 by this measure. That's higher than the 16.8 average since 1960, but it is also lower than past extremes.

Chart #4

Stocks are attractive today because they have an earnings yield of 4.8%, which is substantially higher than the 2.8% yield on 10-yr Treasuries (see Chart #4). Consider: the PE ratio of a 10-yr Treasury bond is 35! With stocks, you get a much better yield than risk-free Treasuries, plus you get plenty of upside should the economy continue to exceed what are still modest growth expectations. These conditions hold only because the market continues to worry that future profits will inevitably revert to their historical mean.

 Chart #5

Chart #5 substitutes after-tax corporate profits using the National Income and Product Accounts for the traditional measure of GAAP profits (i.e., reported earnings). I've normalized the ratio so that the long-term average is similar to that of the traditional PE ratio. Note the extreme overvaluation of stock prices in the late 1990s. Today's valuations by this measure are very close to their long-term average. (I discuss the difference between NIPA and GAAP profits in this post.)

A disinterested observer might look at the charts above and wonder why stocks aren't more expensive, especially relative to risk-free bonds. One reasonable answer would be that the market must be worried about another collapse or correction or even a recession. To be sure, there are legitimate things to worry about, chief among them being that Trump's tariff wars could get out of hand and precipitate a global recession. Quite simply, today's valuations imply that risk aversion is still alive and well, a theme I've revisited many times in recent years.

13 comments:

Flying Robot said...

Great article, and as usual I strongly agree. I am not usually a proponent of reasoning from a single fact (not implying that this article does), but for the past year or so I've felt pretty strongly that corporate profit growth is widely under-estimated.

In fact, I can reflect on ten years of watching a market that I felt was much stronger than prices indicate. Here we are again, and it's just a different set of facts that it seems are being ignored or discounted. Returns may suffer in the next ten years as many pundits predict (and predicted ten years ago) but I am far from convinced. It's been a pretty good ten years for most basic portfolios.

I think 2001-3 and 2008 still haunt people. Surface impressions are often strong.

Benjamin Cole said...

Terrific post. I was looking at corporate profits at the FRED site, and these are the good ol' days when it come to corporations making money. This is great news for everybody. Some of the FRED charts look like skyrockets.

As for market concerns and risk-aversion, I think trade wars are a ripple in the always choppy waters of investing. Investing is not for sissies, and a Pepto-Bismol diet is indicated. Wake me up when human behavior changes.

I do worry about something much deeper---Alexandria Ocasio-Cortez, Bernie Sanders, and elements of Trump's populism.

The short story is this: America is not delivering to its employee class. Housing is frightfully expensive, medical care shot through the moon, and wages dead for 40 years, though more heavily taxed.

Yet the establishment tells the employee class that the solutions are to offshore factories, open borders to desperate immigrants and there is no real solution to high housing and medical costs.

We may see Bernie Sanders in the White House yet, and the establishment is lucky that the charismatic Ocasio-Cortez is too young to run. If Trump can win, Ocasio-Cortez can win.

There are solutions.

Trump may be right on industrial location, and I suspect he is. Singapore has boomed by encouraging (with heavy, heavy government involvement) commercial and industrial location in Singapore. Call it pro-business socialism, but it works.

For housing, I think free markets can solve the problem--but that is the problem: No free markets. No one wants to end property zoning in their neighborhood. If you notice, the libertarians, right-wingers and free-marketeers go mute on the topic. Also mute on decriminalizing push-cart vending. Not a polite topic.

The US spends double (as fraction of GDP) of other advanced nations on health care. Canada, Israel, Australia, Japan, you name it. How is this possible?

Solutions?

Trump actually did another and great tax cut when he doubled the standard education (and received no credit from anyone anywhere, as near as I can tell).

Lower taxes on wages is a great idea. Offset payroll taxes with federal import, sales and property taxes.

End property zoning.

Health care: Throw in the towel and copy Japan. I would say "go to free markets" but America's elderly are on Medicare, and that is dead-end politically.

Things may change, and Ocasio-Cortez may fade.

Trump crushed the GOP establishment to win the nomination and then the Presidency. It wasn't even close.

We may seen the same thing from Ocasio-Cortez some day.

Ergo, I think stocks are priced about right.











Adam said...

Just one observation taken from Brian Wesbury comments.
"More important is that "core" prices, which exclude food and energy, are up 2.0% in the past year, the first time the core index has touched 2.0% on a twelve-month basis in more than six years. In other words, the Fed looks set to be tested sooner, rather than later, on how they will react as PCE prices breach their "symmetric" inflation target.

Benjamin Cole said...

Adam:

Very much worth looking at. Fed Chair Powell has indicated 2% PCE is a target, not a ceiling, so we will see.

The Fed may get pushed to a wall by housing and medicare-care inflation. Fighting housing and medical-care inflation through monetary policy will takes tons and tons of unemployment and much slower GDP growth, so this could get ugly.

Yes, free markets for housing and medicine would do wonders, or single payor for medical care might work. Those options are not on the table.

Cameron Khajavi said...

The us economy is booming - every city I visit and I travel a ton is booming - people are optimistic - once this tarriff nonsense hopefully dies down I really think the market / particularly financials are going to take off - all this inverted yield talk is getting way too much play - we just need tarrif stuff to calm down which is a huge ask so hard to go too risk on but it’s tempting

Frozen in the North said...

What is truly amazing, and drilling below the headlines is that aside from FAANG the market has really be rather flat. Despite corporate America reducing capex and undertaking the largest share buyback program since 2007. Nearly 800 billion of shares were retired this year --

What a surprise.


BTW Cameron if optimism was so high why are wages stagnant?

Mann Wai Yong said...

The mention of Singapore caught my eye. The location of industries here was born out of a need since we have no hinterland, no natural resources, but only people. We were lucky to have very dedicated and smart pioneers who did not squander their chances and thought long-term.

How lucky were we that our founding prime minister told the nation, "Trust me, for I will deliver", and he did! But it also laid the foundation of a host of resentment that we are seeing now.

No system is perfect and I am sure the US will figure her way out.

marcusbalbus said...

time to go back and re read the wealth of nations young buck

Adam said...


http://www.nber.org/papers/w24687
White paper supporting one of Scott's points,i.e."QE had not depressed yields"

Cameron Khajavi said...

Wages aren’t stagnant - they are growing nicely - 3 to 4 percent nominal wage growth consistent with early part of the century - stop drinking the gloom and doom media narrative

An Old Guy in MD said...

Scott said, "One reasonable answer would be that the market must be worried about another collapse or correction or even a recession." What about the negative effects of expanding deficits, and the size of the growing national debt? Congress seems uninterested in dealing with these. How about the fact that 40% of the population receives some kind of entitlement? What about the extreme and growing disparity in the distribution of wealth? These issues, and others are what may be tempering the outlook. Once the FED cuts back on stimulation and interest rates rise, the cost of the debt will rapidly rise adding more to the debt. Inflation may not be far behind. The future don't look so rosy to me.

Do I sound like a liberal? Let me assure you I am a life-long conservative now registered independent. I don't see anyone offering explanation to the questions I raise. Could it be there are no good ones? I'm 78, so maybe it won't be my problem after all.

Scott Grannis said...

Old guy, re debt and deficits: Actually, the current federal deficit is only about 3.7% of GDP, which is quite manageable and only moderately higher than its post-war average. Total federal debt owed to the public relative to GDP is certainly elevated (about 75% currently), but it is not longer surging. Both are within tolerable levels, although much higher than I would like to see. It's a problem but not a disaster, at least not yet.

The number of people receiving checks from the government is way too big in my view, and that I think is one of the reasons the economy has been so sluggish. We're paying people who don't work, and surprise! lots of people aren't working. But that is changing on the margin, I believe, as we are starting to see people re-entering the labor force.

Benjamin Cole said...

Might be time to look at Dr. Copper.

Outside of oil (which is influenced by nut-regimes in Venezuela, Libya, Iran, Saudi Arabia, Russia, you name it), commodities are drifting....