With today's revision to fourth-quarter GDP statistics (which were not surprising and do not change the picture of modest growth and low inflation) comes our first look at corporate profits for the period. After-tax corporate profits, according to the National Income and Product Accounts' calculation, rose 8% last year to reach a new all-time high of $1.74 trillion. Based on this measure of profits, equities still look attractive.
As the chart above shows, after-tax corporate profits have grown substantially faster than nominal GDP since 1989.
After-tax corporate profits as a percentage of GDP (see chart above) are now at their highest level ever. One of the main arguments against buying corporate equities today is that profits relative to nominal GDP are likely a mean-reverting process-so they are very unlikely to continue growing at their recent pace, and could in fact decline significantly relative to GDP in the years to come. I've pointed that out for the past several years, but profits just continue to rise. Of course, this only gives more ammunition to the bears.
The chart above compares the two principle measures of after-tax corporate profits: one uses the NIPA method, which attempts to measure true economic profits (using only data supplied to the IRS in corporate tax filings) and adjusts for capital consumption allowances and inventory valuation); the other is reported earnings per share. Both y-axes are adjusted to reflect a similar rate of growth. I've discussed why the two measures of profits diverged beginning in 1990 here. I think the NIPA measure of profits is superior (HT to Art Laffer, who has been preaching this for as long as I can remember); nevertheless they are both telling approximately the same story. Or are they?
The first of the two charts above shows the PE ratio of the S&P 500 using reported profits (with Bloomberg as my data source). This shows that PE ratios today are only a little above their long-term average. The second chart calculates the PE ratio for the S&P 500 using NIPA profits instead of reported profits. I've normalized this ratio so that the long-term average of the two charts is the same. The NIPA method reveals that PE ratios-which have risen significantly in recent years-are still substantially below their long-term average; which in turn suggests that equities today are attractively valued. (For a discussion of how this compares to Shiller's CAPE method, see here.)
Here's my main point: profits are at record levels by any measure, but PE ratios are average or below average. This is one of the key reasons I think that the market is still priced to very pessimistic assumptions about the future. Equities today are priced to stagnant or declining profits-they are not overly enthusiastic.
Let's go back to the issue of profits having reached all-time highs relative to GDP. Shouldn't we at least feel a little nervous about a mean-reversion process taking hold at some point? To answer that question, I put together the above chart, which shows how after-tax U.S. corporate profits compare to world GDP. Here we see that there is nothing unusual going on. Global profit margins haven't budged for over 10 years. What's happened is that world GDP has grown much faster than U.S. GDP, and U.S. corporations have cashed in on the boom. Today, a greater portion of corporate profits is coming from overseas, where markets and opportunities are much more dynamic than here at home. Apple (NASDAQ:AAPL) can sell iPhones to billions of customers all over the world today, whereas it could only address a much more limited market in the past-primarily the developed countries. Seen from this perspective, there is much less reason to worry about stagnant or declining profits.