Thursday, August 26, 2021

Corporate profits are impressive!

The economy could be doing a lot better, but corporate profits are about as good as they get. Which suggests that the equity market rally still has legs.

Today we received the first revision to Q2/21 GDP, which included the first estimate of corporate profits for the period. GDP was revised upwards by a modest—though still impressive—amount, posting a 6.6% quarterly annualized growth rate. Corporate profits, on the other hand, soared at a 44% annualized rate, and are now at a new, all-time high. All of this despite the fact that the unemployment rate is still quite elevated (5.4%) and there are 6 million fewer people working than at the pre-pandemic high.

If there's a silver lining to the Covid cloud, it is here, in the form of a spectacular increase in the economy's productivity. And with many of those 6 million idle workers likely to be snapped up by desperate employers starting next month (when super-generous unemployment benefits expire), the economy has plenty of room to expand in coming quarters. 

A storm still threatens on the horizon, unfortunately, in the form of the Democrats' $3.5 trillion so-called "infrastructure" reconciliation bill that just passed the House. If the spending it entails ever sees the light of day, it will result in a massive expansion of the welfare state and an equally massive and crushing new tax burden on all of us. The economy will find it very hard to thrive with so much spending, since there is almost certainly going to be many hundreds of billions of dollars wasted due to inefficiencies, perverse incentives, corruption and graft.

So if there's a silver lining to the Afghanistan cloud, it can be found in the recent and precipitous drop in Biden's popularity, thanks to his abrupt decision to surrender to the Taliban. Our ship of state is virtually rudderless, and it strains credulity to think that a seriously weakened administration can actually push through a radical expansion of the administrative state and a massive increase in income redistribution. 

The charts that follow focus on corporate profits and GDP, both of which are looking pretty good these days. I also discuss the outlook for inflation, which is not very good. Finally, I discuss equity market valuation, which by several different measures is not at all outrageous. That's a very good thing.

Chart #1

Chart #1 gives some much-needed, long-term perspective on the economy's growth trajectory. For over 40 years, the economy followed a 3.1% annual growth track. That changed dramatically, however, in the wake of the Great Recession of 2008-2009. Since then, the economy has grown at about a 2.1% rate per year.

Chart #2

Chart #2 zooms in on Chart #1, showing just the past 20 years. Today's economy is about $4.5 trillion below what it would have been had it followed a 3.1% annualized growth track. That represents a potential loss of almost 20% in real national income. What also stands out is the economy's fairly rapid recovery to its 10+ year trend growth track in the past year. 

Chart #3

Chart #2 shows the quarterly annualized rate of inflation across the entire economy (i.e., the GDP deflator). Inflation according to this broadest of measures surged at a 6.2% annualized rate in the second quarter. That's the highest rate by far since the early 1980s. 

Keynesians look at this surge in inflation as an inevitable—but likely only transitory—consequence of the massive monetary stimulus that was necessary in order to get the economy back on its feet in short order.

I agree that this surge in inflation has a monetary source, but I don't believe that expansive monetary policy is what drives a recovery. The Fed has no power to create jobs with its printing press. The most the Fed can do is to provide extra liquidity—which they did to the tune of almost $4 trillion—to satisfy the economy's desire for safety during troubling and highly uncertain times. Without that liquidity it might have been more difficult for the economy to recover. Indeed, the economy might have suffered more without an extra injection of liquidity, because markets might have seized up. 

But looking ahead, an abundance of liquidity is not necessary. As confidence returns and jobs are added and profits increase (!), the economy doesn't need an abundance of liquidity. There's way too much liquidity these days, in fact, which is why short-term interest rates are virtually zero. Yet the Fed has not reversed course; they have not withdrawn excess reserves and they have not increased short-term interest rates. As a consequence "unwanted" money and liquidity are piling up and people are trying to get ride of it. They can only do this by spending the money on "things." But of course that doesn't make money disappear, since the person selling the thing I buy must in turn do something with the money he or she receives.

So the economy finds itself with an abundance of money and people are trying hard to spend that money by buying lots of different things. Real estate prices are up, food prices are up, hotel occupancy is up, private jet travel is surging, commodity prices are up, computer prices are up, and many more prices are up. Shortages are developing. Over time some shortages will disappear, but without the Fed taking action to drain liquidity, prices are unlikely to fall back to where they were. A new equilibrium will eventually be achieved in which most prices are higher (perhaps significantly so), the economy grows, and the current stock of money will have fallen in relative terms to a point in which people are no longer trying to reduce their money balances. 

Chart #4

Chart #4 compares the level of economy-wide corporate profits to nominal GDP. Both are at all-time highs, and it's obvious that corporate profits have increased faster than nominal GDP in the past year.

Chart #5

Chart #5 shows corporate profits as a percent of nominal GDP. Profits have never been so strong relative to nominal GDP.

It's no wonder, then, that equity prices are also at all-time highs. We're in a profits nirvana of sorts, thanks in part to expansive monetary policy, but probably in large part due to corporate efforts to cut costs and streamline their business—all necessary to survival during times of Covid. Extremely low real interest rates are also a boon, since financing costs have never been so cheap. 

Chart #6

Chart #7

Chart #6 is a long-term view of Chart #4. What stands out here is the surge in profits that began around the mid-1990s. Profits averaged about 5% of nominal GDP from 1959 through the mid-1990s, but then they surged to 8-10% of nominal GDP. Years ago I discussed the then-prevailing view among many bearish investors that profits were mean-reverting and would eventually fall back to 5-7% of GDP. I disagreed, since I saw the rise in profits as a boon triggered by globalization. China's big boom started in 1995, not coincidentally. As world markets globalized, successful firms found themselves operating in a much bigger market with seemingly endless possibilities. Chart #7 compares US corporate profits to global GDP, and by this measure not much has changed over time. (The chart only covers the period ending 12/20.) Since global GDP has grown faster than US GDP, global corporations have seen their sales rise relative to the size of the US economy.

Conclusion: it is not necessarily the case that profits have to fall back to some much lower level of nominal GDP. Profits are arguably sustainable at current levels. That further suggests that equities are not necessarily or fundamentally overvalued at current levels.

Chart #8

Chart #8 shows my calculation of the PE ratio of the S&P 500 using the National Income and Product Accounts measure of corporate profits (the source for profits shown in the above charts) as the "E" instead of the traditional 12-month trailing average of GAAP reported profits. Yes, PE ratios by this measure are high, but nowhere near as high as they were in 2000. 

Chart #9

Chart #9 compares NIPA corporate profits to reported profits (12-mo. trailing average of adjusted profits, according to Bloomberg). These two different measures tend to track each other fairly well over the years, except that NIPA profits, being based on the most recent quarter, usually point the way to trailing profits. What that means is that there is likely more good news to come for the stock market. 

Chart #10

Chart #10 shows the risk premium of the S&P 500, which I calculate by subtracting the 10-yr Treasury yields from the current earnings yield of the S&P 500 (which in turn is the inverse of the reported PE level). What we have today is a relatively attractive risk premium. Equities, in other words, are not necessarily overpriced at all. In fact, during the bull market of the 1980s and 90s, the risk premium was negative. 

Brian Wesbury, Art Laffer and I all use a similar model to value the equity market. This model assumes that the discounted present value of future profits guides current market valuations.  This is a capitalization model which essentially divides current profits by the current 10-yr Treasury yield to get a sense of where the fair value of stocks is. When discount rates are low, such as they are now (10-yr Treasury yields are only 1.3% or so!) then the fair value of equities should be high.

At this point one should be worried about what happens when interest rates revert back to a higher level (where they should be given the prevailing rate of inflation). Does the inevitable Fed tightening mean that the stock market is headed for another crash? Not necessarily.

By my calculations, equities today are priced to almost a 4% discount rate. If they were priced to a 1.3% Treasury yield, then the fair value of equities would be multiples of what it is today. In other words, the market is already assuming that rates rise, so rising rates needn't be the death knell for equity markets.

UPDATE: Since this post includes a description of how I see monetary policy becoming a force for rising prices, I recommend reading my June post on the subject of inflation in Argentina: Argentine inflation lessons for the U.S. 

16 comments:

  1. Chart #7 is absolutely fascinating. So many questions.

    The U.S. share of global GDP actually dropped substantially, all while corporate profits maintained the same level. In 1960 it was about 40% (!!!) while now it's around 24%. <- this, by itself, is the the reason for de-globalization and plenty and foreign policy. The share shrinks but the cost is still the same, and even higher.

    1. It seems obvious corporate profits increased following the QEs. It will stop when the QEs stop.
    2. Regarding the S&P500, FAANGs make about 20%.

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  2. I'm wondering how much of the growth in profits is due to a loss of competition from small "mom and pop" operations due to covid? Corps. were much better able financially to weather that storm, no?

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  3. The inflation we have recently seen has been driven by temporary declines in productivity. A lot of factories and industries were idled during Covid resulting in decreased output. A lot of unemployed workers have been paid more to stay home than work. This has manifested itself in inflation seen in prices from barbers to computers to cars, etcetera. Monetary policies do not by themselves create inflation, decreases in incentives and productivity do.

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  4. Kudos to Scott Grannis once again and especially for his observations regarding corporate profits.

    These are the good old days when it comes to corporate profits.

    So much doom-saying out there, but this simple fact should be remembered and also that large private corporations are the only big organizations that operate efficiently.



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  5. Agree with Skydude...I didn't magically find extra cash lying around my house that I "had" to spend. Did any of you? Someone must have. Please explain how monetary policy alone can cause inflation. Believe it or not, I learned MV=PY. I just don't see how it works from my own little view out the window.

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  6. >"So if there's a silver lining to the Afghanistan cloud, it can be found in the recent and precipitous drop in Biden's popularity, thanks to his abrupt decision to surrender to the Taliban."

    For the record, Biden is just following through on the shit sandwich that Donald Trump left him.

    * It was Trump who reduced troop strength in Afghanistan from 15,000 to 2,500.
    * It was Trump who negotiated a peace deal with the Taliban--agreeing to get U.S. forces out of the country by May 2021--and excluded the Afghan government from those talks.
    * It was Trump who pressured the Afghan government to release 5,000 Taliban prisoners.
    * And it was Trump who recently said, "I started the process. All the troops are coming back home. They couldn’t stop the process. Twenty-one years is enough, don’t we think? Twenty-one years. They [the Biden administration] couldn’t stop the process. They wanted to, but it was very tough to stop the process."

    Are there problems? Yes. Could Biden have done it better? Arguably yes. But Joe Biden is not the guy who surrendered to the Taliban.

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  7. "It was Trump who reduced troop strength in Afghanistan from 15,000 to 2,500.
    * It was Trump who negotiated a peace deal with the Taliban--agreeing to get U.S. forces out of the country by May 2021--and excluded the Afghan government from those talks."

    The Trump agreement is conditional. The second two points of the agreement were broken, and Biden had all authority needed to change what the US was doing in Afghanistan.

    From the agreement:
    "prevent the use of the soil of Afghanistan by
    any group or individual against the security of the United States and its allies"

    The wording was done skillfully to allow the US to do whatever it wanted if violence was threatened or committed.

    It was Biden's decision, and lack of military competence that caused the problem.

    Nowhere in there does it say things like:
    1. Air bases must be surrendered
    2. Armed forces leave before civilians


    But, because a lot of people have been air lifted out, it's all a success! /sarcasm off

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  8. Rick, fair points about Trump. The problem I have with that take though is unwillingness to acknowledge how badly the Biden administration appears to be managing - and not just in the pullout. The unbridled joy and confidence with which the intelligentsia and media welcomed the Biden administration was semi-nauseating. News reporters openly weeping that finally adults were back in charge. Science and Truth! In reality this administration has been just as inept, just as willing to outright lie (too many to cite), twist the science for political gain (Covid), engage in corruption (no, not Hunters paintings, but the massive inevitable corruption to come with the spending packages - see Al Gore and the teachers unions) In a non-partisan view the last administration that was half decent - at least in terms of attempting positive policy making- was Bill Clintons. Glad to see you post by the way.

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  9. wkevinw said:

    It was Biden's decision, and lack of military competence that caused the problem.

    Nowhere in there does it say things like:
    1. Air bases must be surrendered
    2. Armed forces leave before civilians


    Do you seriously think that Joe Biden told the SecDef and Chairman to do that stuff? Do you seriously think that that's how it works? If you do, then you shouldn't be trying to call out anyone else for lack of military competence.

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  10. randy said:

    The problem I have with that take though is unwillingness to acknowledge how badly the Biden administration appears to be managing - and not just in the pullout.

    First of all, your operative word is appears. If you haven't read Herodtus's Histories, you should do so, and focus on the story of Solon and Croesus. This story is not over yet, and until it is, and all the facts are in, everyone should withhold judgment.

    Biden inherited a shit sandwich . . . he's the President who had the balls to finally pull the plug . . . and so far over 100,000 people have been evacuated. I read somewhere it's the largest evacuation of its sort in history.

    Could it have gone better? Certainly. Would Trump have done better? Well, Donald Trump is the one who abandoned our Kurdish allies in Syria to get slaughtered by the Turks:

    The Kurds Have Paid Dearly for Trump's Recklessness

    So I tend to think that for all the flaws, the Biden administration's handling of the situation is a bit better than what the alternative would have been.

    As far as the rest of your post, I am not here to defend the Biden administration, other than to say it was not Joe Biden who surrendered to the Taliban.

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  11. Pushback on the corporate-profits aspects
    In 1999, in a rare comment about the general valuation levels, Mr. Buffett had suggested that expectations of persistently higher corporate profits (as a percentage of the total economic pie) came with certain (divisive) risks. He's been partially wrong so far, no doubt in large part due to the unprecedented public debt meteoric rise used as a mitigating factor. Is that sustainable?
    Are higher corporate profits a sign of productivity or efficiency gains or are they more a revelation of decreased competition and dynamism. The data i look at suggest more the latter.
    Chart #8, about the S&P vs NIPA profits is super interesting but may be misleading as there seems to be clearly an aspect that could be called the Nifty 500. If you go to FRED data (i don't know how to include a graph in this post) and build the Wilshire 5000 over NIPA corporate profits (without ICA and CCAdj) graph, you obtain (IMHO) a better representation of valuation levels for Corporate America. You then 'see' the following related to this aggregate PE measure:
    -Present levels (as presently reported) are similar to the dot-com peak
    -Present levels are 2-3x compared to pre-GFC levels
    -Present levels are about 8x compared to the late 70s

    For those ready to suggest low interest rates as a clear cause, please remember that the correlation between low interest rates and high valuation levels on a consistent basis is quite a recent phenomenon and for much of financial market history such positive correlation has not happened and has even been negative for relatively long periods. Of course, this time could be different.

    For the nerds interested in how NIPA profits are 'constructed', please be aware of a new and very significant phenomenon (that showed up slightly during the dot-com peak period): NIPA corporate profits have recently been overall corrected down over time with the realization of profits from huge stock-based compensation packages (some of this value recognized in S&P GAAP earnings based on grant-date value but most of it recognized in NIPA once tax assessments are integrated over time at the individual level, based on vest-date value). If share-based compensation is not a corporate expense, then what is it?. This means that within 2-4 years, we will find out through NIPA profits that present profitability is overstated and present PE levels are even higher than during the dot-com era and, in fact, compare to the Japan late 80s era.
    Of course, present-day optimism may be warranted, contrary to other bu**le episodes. However, one should discount other possibilities. Present investment activity being a precursor of future profits, you may want to note that, out of the operating earnings that corporations produce (and that presently benefit from record low tax and interest costs), net investment per GDP is reaching new lows and capital flows to share buybacks per GDP (mostly to compensate for dilution as a result of share-based compensation) is again reaching new highs.

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  12. "Do you seriously think that Joe Biden told the SecDef and Chairman to do that stuff? Do you seriously think that that's how it works? If you do, then you shouldn't be trying to call out anyone else for lack of military competence."

    "How Biden’s team overrode the brass on Afghanistan" https://www.politico.com/news/2021/04/14/pentagon-biden-team-overrode-afghanistan-481556

    On the Trump decision, yep, the Kurds paid a price, as they would have in almost any scenario. Also the "Kurds" are not even monolithic. There are at least a couple very different factions with different politics and military mission.

    Getting rid of any of these entities, e.g. ISIS, Al-Qaida, President of Libya, Syria, etc., will cause a lot of death and destruction, no matter what you do. The only thing that gets credit is withdrawing in an orderly and safe process ]for American interests as first priority. Sitting at your desk and saying "end the war", gets no credit. Anybody can do that.

    Note- I lived in that part of the world for several years, and understand it maybe better than our beloved POTUS, in fact.

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  13. "If there's a silver lining to the Covid cloud, it is here, in the form of a spectacular increase in the economy's productivity. And with many of those 6 million idle workers likely to be snapped up by desperate employers starting next month (when super-generous unemployment benefits expire), the economy has plenty of room to expand in coming quarters."

    Per the SF FED, the productivity gains will most likely diminish.

    https://www.frbsf.org/economic-research/publications/economic-letter/2021/august/labor-productivity-in-pandemic/?utm_source=mailchimp&utm_medium=email&utm_campaign=economic-letter

    As far as employers snatching up those six million workers, that is TBD. Workers per a recent Shepard Smith telecast on CNBC that were working from home were also employed by another employer. Yes, some employees were doing two jobs within the 40-hour or so workweek. Moreover, if an employer wanted their employee to return to the worksite on a full-time basis the employer was meeting resistance. One employee began searching for another work from home employer and was successful in securing employment within one week!

    The upshot is similar to how the Black Plague empowered the peasants could the Sars-Covid empower the working class?

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  14. "The upshot is similar to how the Black Plague empowered the peasants could the Sars-Covid empower the working class?"
    This is quite a controversial topic actually. Excess mortality then was incredibly high and this had mixed effects on both demand and supply. There seemed to be a period of 'good' deflation followed by high inflation with real wages not making great progress over the longer period following the pandemic.
    i agree with the likely disappointing aggregate productivity numbers going forward. Some able workers are calculating opportunity costs when considering going back to work and are considering various key aspects: government transfers, cost of child care and potential 'cost' of exposure to the coronavirus (this is definitely a factor in the relative absence of recovery in the labor participation rate of older cohorts). These factors are contributing to transitory and inflationary wage pressures but secular trends continue to be in place to maintain wage repression. The aggregate bargaining power remains weak. Industrial jobs have gone down and have been mostly replaced by low productivity jobs in the following sectors: education, health, various low-skill 'services', various 'government' jobs, accommodation and food etc. These are the sectors which show growing employment these days. Simpson's paradox is at work here with more people going to work translating in lower productivity numbers in the aggregate.
    An aspect which is interesting is that the unprecedented US combined monetary-fiscal policies recently supplied sustained domestic consumption (inter alias of foreign goods) giving rise to a very unusual rise in trade deficits during a 'recession' and providing support for global and outsourced workers' wages!
    Of course, that's good for corporate profits but is this the best use of capital for sustainability?

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  15. wkevinw said:

    Note- I lived in that part of the world for several years, and understand it maybe better than our beloved POTUS, in fact.

    That part of the world was my sub-specialty in the military; had I chosen to do so, I could have been designated a Foreign Area Officer (FAO) for the region. And having spent 23 years on active duty, I dare say I may understand it a bit better than you.

    https://www.politico.com/news/2021/04/14/pentagon-biden-team-overrode-afghanistan-481556

    Read carefully. What Biden did was tell the military to make it happen, he did not tell them how to make it happen. Furthermore, if you read the article, you will find that Politico did not bother checking with The White House or National Security Council to verify the accuracy of the article. Quote:

    Had they done so, we would have said that this was a completely inaccurate and poorly-informed storyline coming from former officials who were not even part of the policy process the Biden Administration ran on Afghanistan.

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  16. "Corporate profits are impressive!"

    You know what else is impressive? THIS BLOG! Thanks Mr. Grannis.

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