Corporate profits are impressive, but valuations are merely average

With last week's release of revised GDP statistics for Q3/15, we learned that after-tax corporate profits in the 3rd quarter were down 3.2% from the second quarter, but were up 1.4% from year-ago levels. The growth in profits has slowed significantly in recent years, but profits were still 9.9% of nominal GDP last quarter, just shy of their all-time high of 10.8%, which was set three and a half years ago. To put that in perspective, consider that after-tax corporate profits have averaged about 6.5% of nominal GDP since 1959, and as recently as 11 years ago, profits had never exceeded 8% of GDP. 

At a time when corporate profits have been unusually strong relative to nominal GDP, it is worth noting that investors' valuation of those profits (i.e., how much they are willing to pay per dollar of profits) is only about average, according to a variety of measures detailed below. Current valuations thus appear to incorporate a substantial amount of skepticism about future profits. Put another way, there is no evidence here that equity valuations are in "bubble" territory. Instead, and as I've been noting for years now, it would appear that the market is priced to the expectation that corporate profits will sooner or later regress to their long-term mean—which would in turn imply years of no growth or declining profits. But as I've also noted, that may be an overly pessimistic view, given that corporate profits today are about average when compared to global GDP.

The chart above shows two versions of after-tax corporate profits: one, a comprehensive measure compiled by the National Income and Product Accounts (aka the GDP stats), and the other the earnings per share of the S&P 500 companies. Both are close to all-time highs, and both have increased by roughly the same order of magnitude over the past 5-6 decades. Both show relatively slow growth of late. There are some important differences between the two which I discuss in detail here, but by and large they are telling the same story.

 

The chart above compares the NIPA measure of after-tax corporate profits to nominal GDP. This has averaged about 6.5% since the 1950s, but for the past several years it has been significantly higher. Is this series mean-reverting? That is the question investors have been asking themselves for years. Many worry that it is.

I've been arguing for years that corporate profits relative to GDP are not necessarily going to revert to their historical mean of 6.5% because of globalization. Major U.S. companies now earn a substantial portion of their profits overseas, and overseas markets have grown much faster than than the U.S. market (think China and India). When profits are measured relative to global GDP (see chart above) they are only slightly above their long-term average. 

One traditional measure of valuation is the ratio of equity prices to earnings, shown in the chart above. Here we see that current PE ratios of 18.6 (according to Bloomberg) are only moderately above their long-term average of 16.7. Valuations today aren't even close to what they were in 2000, when we now know stocks were in "bubble" territory. 

The chart above is my version of PE ratios: it uses the S&P 500 index as a proxy for the price of all companies, and it uses the NIPA measure of after-tax profits as the "E." I've normalized the series so that its long-term average is similar to the standard PE measure shown in the previous chart. Here again we see that valuations today are about average. 

While on the subject of PE ratios, the chart above compares PE ratios to the real yield on 5-year TIPS, which in turn is arguably a good proxy for the market's sense of the real growth potential of the U.S. economy. With the exception of the 2004-2008 period, these two series display a remarkable correlation, which I think makes sense. (That period might be explained by noting that the Fed was too aggressive in tightening monetary policy—pushing real rates artificially high—and that contributed to the crisis of 2008.)

When real yields on TIPS were around 4% in the late 1990s,the U.S. economy was booming and investors expected the good times to continue to roll. That expectation was fully embedded in PE ratios, which were unusually high. Investors were so confident that economic growth and profits would be strong that they were willing to pay a huge price for those profits. Since then, growth expectations and real yields have declined and, not surprisingly, PE ratios are much lower. The market is not very enthusiastic about the prospects for growth and profits, and that's why equity valuations today are merely average. It's a cautious market, not an irrationally-exuberant market. But on the margin, real yields and PE ratios have been moving higher; the market is becoming less risk averse as confidence slowly returns.

Caution is also reflected in the chart above, which shows the difference between the earnings yield on stocks (the inverse of PE ratios) and the yield on 10-yr Treasuries. In order to satisfy investors' aversion to risk, the market demands a yield on stocks that is about 4% higher than the yield on safe Treasuries. Today's equity risk premium is substantially higher than its long-term average.

The chart above compares the earnings yield on stocks with the yield on BAA corporate bonds (a proxy for the typical large company that issues bonds). Finance theory would say that in "normal" times the yield on a company's bonds should be higher than the yield on its equity. That's because the potential return to owning corporate bonds is limited to their coupon, whereas the potential return to owning stock is theoretically unlimited, since earnings can grow significantly over time. Investors should be willing to pay a higher price for the stock (and consequently accept a lower yield) than for a bond of the same company. Today bond yields and earnings yields are about the same. For the same price as a bond, equity investors get much more upside potential; that in turn implies that equity investors don't see much upside potential—if any—to corporate earnings. 

The chart above illustrates one simple rule of thumb which attempts to reveal whether stocks are over- or under-valued, or just about right. The Rule of 20 says that the stock market is fairly valued when the sum of the average price-earnings ratio and the rate of inflation is equal to 20. Above that level, stocks begin to get expensive; below it, they’re bargains. In the chart I've added together the EPS of the S&P 500 and the year over year rate of inflation according to the core PCE deflator, the Fed's preferred measure of inflation. The sum today is just about exactly 20 (18.6 + 1.3), which puts equity valuation squarely in "average" territory.

To summarize: if there is a common theme to the charts and discussion above, it's that stocks are not obviously over-priced or under-priced. Valuations are likely in the range of what a conservative investor might call "reasonable."

Congratulations, Argentina!

The citizens of Argentina today turned a new page in Argentine history by voting out the Peronists after 12 troublesome years of rule. I've written several times over the years about the ravages of Peronism and the disturbing echoes of the same here in the U.S. It's a relief to know that things should be changing for the better. Congratulations to all my friends and family in Argentina!

The new president, Mauricio Macri, promises to be much more business friendly than the outgoing Cristina Kirchner. Although he is quite likely to officially devalue the peso, it will only be to the extent that it has already been devalued in the black market. If he successfully pursues the right policies—liberalizing the exchange rate market, lowering the punitive taxes and tariffs on exports, and squeezing out wasteful and corrupt government spending, to name just a few—it would not be surprising to see the peso strengthen a bit from the 15 pesos/dollar level that has prevailed in the black market. Once capital knows that it is free to leave, once creditors know that their loans will be repaid, once exporters know they can keep the fruit of their efforts, then the capital outflows of recent years should reverse. Already the stock market has been celebrating in anticipation, turning in one of the strongest performances in the Western Hemisphere.

Like the U.S., the Argentine economy has been underperforming for years. It only takes a few things to go right in order to unleash stronger growth.

PS: Macri takes over beginning December 10th.

Bank lending still booming

Outstanding loans at U.S. banks have increased over $800 billion in the past 12 months, and have been increasing at about a 7.5% annualized rate over the past year and two years. One area of bank lending—Commercial & Industrial Loans—has been expanding at 10.5% annualized pace for the past 5 years, and has expanded by over $200 billion in the past year, up 11.6%. Banks still have over $2.5 trillion of excess reserves (reserves in excess of what is required to collateralize their deposits), so bank lending could theoretically continue to expand at heady rates almost indefinitely.

As the chart above shows, the pickup in bank lending got started about two years ago, after being very weak from 2008 through 2013. It may just be a coincidence, but bank lending started picking up right around the time—in early January 2014—the Fed announced that it would "taper" its purchases of notes and bonds, which turned out to be a prelude to the end of the third round of Quantitative Easing. Prior to that time, banks had apparently been eager to accumulate excess reserves, and relatively unwilling to lend to the private sector. In effect, by accumulating excess reserves, banks were lending principally to the Fed. In the past two years this has shifted, with banks lending much less to the Fed and much more to the private sector. 

C&I Loans (shown in the above chart) are a good proxy for bank lending to small and medium-sized companies—those that are too small to access the capital markets directly by selling bonds. They've been on a tear every since the end of 2010. I've interpreted this to mean that banks as well as businesses have become more confident in the future: banks are more willing to lend, businesses are more willing to borrow. Lending isn't always good for economic growth, but in this case I think it has helped boost growth, because it is the result of increased confidence. The big international corporations may be borrowing to fund dividends and buybacks (and avoid double and triple taxation on their foreign profits), but I doubt that is the case with much smaller companies.

There is no sign here of any deterioration. Lending activity remains robust, and that suggests that the underlying economic fundamentals of the economy have not deteriorated and are possibly even improving. This lends support to the Fed's decision to start normalizing interest rates.

Since increased lending is a reflection of a reduced demand for money (borrowing money is like shorting a stock: you benefit if the value of the stock declines), it is entirely appropriate for the Fed to adopt a policy that attempts to offset that decline in the demand for money. Raising the interest it pays on excess reserves makes banks more willing, on the margin, to hold those excess reserves and less willing to increase their lending to the private sector. However, increasing IOER to 0.5% is unlikely to make a big difference, so we should expect to see further rate hikes going forward.

The risk the Fed runs is raising rates too little, too late. That's what has happened in nearly every business cycle expansion, and it explains why inflation almost always rises until the point when the Fed has finally "caught up" and tightened by enough to severely constrain the supply of credit—at which point the economy slips into recession. We are still years away from another of these credit roller-coaster rides, but that doesn't mean we don't need to worry.