Sunday, September 1, 2019

Another look at corporate profits

A few days ago, the second revision to Q2 GDP gave us our first look at corporate profits for the quarter. My preferred measure of profits is after-tax, with adjustments for inventory valuation and capital consumption allowances, as calculated in the National Income and Product Accounts (NIPA). As Art Laffer is fond of saying, this represents "true economic profits,” and it is a consistent measure that goes back a long time. On that basis, second quarter profits rose 5.1% from first quarter profits, but for the year ended June '19, profits were up only a modest 2.7%. Over the past 5 years, profits have grown at an annualized pace of just 1.9%. Not very impressive, right? Well, not exactly. Here's some context which puts profits in a more attractive light:

Chart #1

Chart #1 shows 60 years of corporate profits compared to nominal GDP. Note that the y-axes are both plotted using a semi-log scale, and both are scaled identically (i.e., the top value is 150 times the bottom value). Lines plotted thusly have an identical slope if their growth rates are also identical. What stands out here is that corporate profits have handily outpaced nominal GDP growth since 2001.

Chart #2

Chart #2 uses the same data as #1, dividing profits by GDP. From 1959 through 2001, profits averaged a about 6.1% of GDP, and they were mean-reverting around that value. Since 2001, however, they have averaged 8.7%, with no signs of a mean reversion to 6%. In short, corporations these days are generating profits on a scale never seen before 2001: for the past 17 years corporate profits have averaged a higher percentage (about 40% higher) of GDP than they ever saw in prior years. That translates into a roughly 40% increase in profits when measured against GDP .

Chart #3

theorized over 6 years ago that, due to globalization, US corporations' ability to boost sales and profits had increased significantly, and this explained why we shouldn't expect to see a reversion to the old profits/GDP mean. In a rapidly-globalizing world, expanding foreign markets allowed US corporations to significantly and permanently expand their sales. As Chart #3 shows, corporate profits have averaged about 2% of World GDP since 1960, with some signs of mean reversion around that mean. In other words, while corporate profits are running strong relative to our economy, they are simply keeping pace with the much-faster growth of the world economy.

Chart #4

When profits surged to over 10% of GDP in the early years of the current expansion, most observers expected them to revert again, which is why PE ratios were depressed despite spectacular growth in profits (see Chart #4 and this post for more details). Today PE ratios are about 15% above their long-term average, but then again, profits continue to be a much larger percentage of GDP than they have been over the long term. I don't see any cause for concern over current PE ratios.

Chart #5

A few years ago, in a post entitled "A better PE ratio," I discussed an alternative way to measure PE ratios using the S&P 500 index (a good proxy for total market capitalization) and dividing it by NIPA profits (arguably the best measure of total corporate profits). I've done that in Chart #5. Note that the ratio is normalized so that its long-term average is equal to the long-term average of the standard measure of PE ratios (just under 17), which divides stock prices by trailing 12-mo. earnings per share (EPS). Both PE ratios today are running about 15% above average.

Chart #6

Chart #6 shows both measures of profits, again by using two y-axes with similar ratios and a semi-log scale. Note that the "gap" between NIPA profits and EPS profits has closed rather dramatically in recent years. Much of that came about thanks to a downward revision to past years' NIPA profits announced earlier this year. In any event, both measures of profits seem now to be tracking each other more closely, and both give rise to similar PE ratios. Neither measure suggests that equity valuations are excessive. PE ratios are above their long-term average, but profits are in general much more abundant, relative to GDP, than they have been over the long haul. What's not to like about this?


Benjamin Cole said...

Always great to see the charts on corporate profits. We see some slipping, but remember (as Scott Grannis points out) profits are still very solid from a historical context. These are the good ol' days for corporate profits and I am happy for that. Profits mean businesses can invest in plant, equipment, R&D, pay good wages. The Trump-GOP tax cuts must be helping.

It is interesting to ponder, as Scott Grannis suggests, that US-listed companies are becoming globalized. I guess, to some extent, the globe could have a great economic year while the US has a mediocre year, or vice-versa, but the S&P 500 might be "globe-centric."

This exposure of US-based multinationals to the globe and China might be one reason why Trump trade policies are treated as such huge, critical news in the financial media (S&P 500-centric), but not so much on Main Street. My take is as long as the US is generating profits and jobs, not that much can go wrong.

I hope for lots of great years and prosperity ahead for everybody.

steve said...

Lizzie Warren would read this post and respond "those meanie pants business people! Raise their taxes! Confiscate their wealth! Choke off economic growth! (well, she wouldn't say the last part)

Rich said...

Another read on main street:

Per today’s Axios AM email:

Consumer sentiment fell to its lowest level since October 2016 and dropped by the most since December 2012, according to a survey by the University of Michigan, Axios Markets editor Dion Rabouin writes.

Why it matters: The decline in sentiment was attributed largely to negative references to tariffs and the U.S.-China trade war, said Richard Curtin, the survey’s chief economist. Tariffs were mentioned "spontaneously" as a negative force by one in three respondents.

The Cliff Claven of Finance said...

Stocks climb as confidence increases

That's why it is so hard to predict a recession.

People are confident, and the economy seems to be healthy, then a few months later, it's not.

After the confidence peaks, a bear market soon starts.

Then worries begin increasing until "peak worries" is reached.

Then a new bull market soon starts

The Commodity Guy said...

Scott, you are using the value of NIPA profits versus the S&P EPS. I believe the number of shares of the S&P has been declining because of stock buybacks. Apples to apples, you should use the value of S&P earnings.