Corporate Profits Continue Strong

Includes: SPY
by: Calafia Beach Pundit

Today's first revision to Q2 2013 GDP growth (which was revised up from 1.7% to 2.5%) brought with it the first look at corporate profits for the quarter, and the news was excellent. After-tax corporate profits rose to a new all-time of $1.68 trillion, up 7% from a year ago. This is actually within the realm of astonishing if one considers that this measure of profits (arguably the best measure of "true" or economic profits) has increased 218% since the first quarter of 2000 (when the S&P 500 hit its peak for the year), yet the S&P 500 is up only 7.5% since then. With the benefit of hindsight we know that stocks were grievously overvalued in 2000 -- but that can hardly be the case today.

Note how strong corporate profits have been since 2000, despite the current sluggish recovery (actually the weakest recovery in history).

The chart above provides a long-term perspective on how corporate profits behave relative to nominal GDP.

Relative to nominal GDP, corporate profits today are just shy of an all-time high.

Using the methodology explained in my article last week, the chart above shows the P/E ratio of the stock market using the NIPA measure of after-tax corporate profits instead of trailing 12-month earnings. This suggests that stocks currently are trading about 25% below their historical average P/E. This is also astonishing since P/E ratios tend to track interest rates inversely (i.e., P/E ratios tend to be low when market interest rates are high, and vice versa).

Ten-year Treasury yields are still extremely low from an historical perspective, yet P/E ratios are quite low from the same perspective. This suggests that the market has hardly any confidence in the ability of corporate profits to maintain current levels. Instead, it seems like the market is priced to the expectation that corporate profits will "mean revert" to their long-term average of 6%-6.5% of GDP.

But as I've argued before, it is not necessarily the case that corporate profits have to, or are likely to, revert to some historical mean relative to GDP. U.S. corporations are increasingly operating in a rapidly expanding global economy and marketplace. As the chart above suggests, corporate profits relative to global GDP are still fairly close to their long-term average. Thus there may be little reason to think that profits need to decline significantly or that they are at unsustainably high levels today.

NIPA profits and reported earnings tend to track each other over time, with NIPA profits tending to lead trailing earnings. This suggests that reported earnings are likely to continue to grow. At the very least, the news on corporate profits provides solid support to the current level of equity valuations. Viewed from an optimistic perspective, stocks would appear to have lots more upside potential and could be considered significantly undervalued.