Back in July, I wrote an article suggesting the use of NIPA Corporate Profits as a yardstick for measuring the level of the S&P 500 index. NIPA stands for National Income and Product Accounts, one of which is Corporate Profits. The US Bureau of Economic Analysis includes this number as a sub account in GDP, and as such it is logically consistent with GDP.
At the time, with the S&P at 950, Corporate Profits suggested that a more normal level for the index would be 1,200. As the situation developed, the S&P has since made substantial progress closing the gap. Tuesday's revision of GDP updates Corporate Profits through the end of the 3rd quarter, and it is now possible to develop a revised target or normal level for the S&P based on the new information.
Here are updates of two charts: The first plots the two sets of data over time; the second is a scatter chart which derives a formula for the S&P as a function of Corporate Profits. (Click charts to enlarge)Click to enlarge
Click to enlargeThe Magic Number - Corporate Profits came in at $1,356 billion, up a startling 10.6% for the quarter. Applying the formula from the chart, I get 1,356 X .80 = 1,084 + 181 = 1,265, round to 1,250. From Monday's close of 1,106, this implies a further increase of 13%. Under this scenario, equities are still an attractive investment, although the 30% that was out there in July has mostly been realized and from here the risk/reward ratio is less attractive.
Refinements – This approach has the advantage of simplicity. In an effort to improve predictive power, it is possible to introduce other variables into the equation. Interest rates and unemployment are two primary concerns: the first can be related on a mathematical basis, the second is more of a judgment item.
Interest Rates – For purposes of comparing equity earnings yields to bond yields, I am using the Moody's Baa corporate bond rate, available daily or weekly from the Federal Reserve. This number displays a strong inverse correlation with the S&P. As you might expect, consideration of current interest rate levels suggests a higher target. After fiddling with the numbers a while, I get a target value of 1,321, round to 1,300.
Unemployment – Also displays an inverse correlation with the S&P. The period of time used does not include any episode of high unemployment comparable to what we have today. Developing a formula that accounts for both interest rates and unemployment, and that tracks history acceptably, I get an indication of 1,035, round to 1,050. The question here is about unemployment as a trailing indicator, vs. the intuitive view that the economy cannot recover without an increase in employment.
Corporate Profits increased 14.5%, in spite of the unemployment. Or perhaps because of the unemployment. If you fire people faster than your business declines, profits will increase. My feeling is that corporations have become much quicker to lay off in the face of slowdowns, or even when business conditions are acceptable but higher profits are desired. The attitude of management is, let them sleep under bridges, we are going to make a profit. It seems to be working, and I am unable to rule it out as a possible ongoing trend.
The jobs may reappear in China, elsewhere in Asia, or in other low cost areas. Outsourcing or EMS may be beneficiaries as well. American citizens may take back jobs that were relegated to more willing workers, illegal immigrants.
Public policies aimed at creating employment may have some success when developed and implemented. Incentives to make capex in America, I mean building factories here and installing state of the art machinery here, attractive would be a big help. American public policy is a patchwork, with the states bidding against each other in an effort to attract business investments, and no uniform and coherent policy to ensure that this is done most effectively to maximize employment for the nation as a whole.
The US has a more than adequate supply of housing, and the last time I saw figures on it there were more registered vehicles than licensed drivers. Excessively lenient credit policies drew several years worth of demand forward and it is not realistic to look for a strong rebound in employment until consumer deleveraging and supply absorption have run their course.
Conclusion – After putting this through the blender, I plan to invest along lines that will be profitable if the S&P ranges from 1,050 to 1,250 by the end of 2010. I will continue to monitor Corporate Profits and revise my thinking based on developments.
Disclosure: No positions mentioned, the author is net long equities