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I was intrigued by a top story on Bloomberg yesterday which presented historical data on the relationship of total corporate profits to GDP. You may have seen the article, or at least heard people talk about record corporate profits and profit margins. Here's the chart:

click to enlarge
Boughton Grab Chart

Questions:

Are corporate profits peaking?
And what does the chart tell us about whether to commit capital to stocks?

Analysts have posited several explanations for high corporate profit margins, from technologically driven productivity improvements to "permanently low" interest rates to the perpetually upward march of capitalism. Without going into the counter-argument that folks in the 1960s felt much the same way, I will note two things from the chart: one, this ratio never seems to stand still… it is extremely volatile historically; two, the current level is more than a two standard deviation event. This says to me that corporate profits are likely to fall from these levels, if history repeats itself. That may be due to a combination of lower consumer demand [as consumers will have to reduce spending to pay down record debt levels], higher wages, higher raw material costs, more government regulations, geo-political troubles, or simply gravity.

Now, is this bullish or bearish? What does the stock market do from here? Let’s use history as a first guide. The prior peak in profits as a % of GDP was 3/31/66. What did the stock market do after that? You probably know that the annualized return of the S&P 500 for the following ten years was less than 2% [8-9 years was negative], while inflation ran at nearly 6%. At the end of that period, corporate profits had recently hit a new low as a percent of GDP, and you could buy stocks for an average PE around 8. 1966-1976 was not a great time to invest in stocks! See the chart below:

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Boughton Comparative Returns Chart

Several counter-arguments are obvious:

1) How do we know corporate profits are currently peaking? Maybe they have more room to rise.
2) Corporations are fundamentally different now, more efficient, computerized, more productive.
3) History may not repeat.

Without addressing the counter-arguments specifically [though the wise saw about those ignoring history being doomed to repeat it does come to mind], it occurred to me to look into the other two major factors which, according to extensive research, are the most predictive of future stock market returns: 1) valuation, and 2) interest rates. What, if anything, do these two major indicators tell us about the prior peak in corporate profits vs. today’s [possible] peak?

The similarities are, in fact, frightening. As of 3/31/66, the PE on the S&P 500 was 16.95. Indistinguishable from today’s levels. [As mentioned above, within 8 years, PEs were around 8.] Clearly, a "low" PE level of 17 has not in the past prevented a serious bear market. How about interest rates? On 3/31/66 the 10-year Treasury yielded 4.87%. Very close to today’s 4.51% and even closer to a month ago 4.83%. Interest rates historically don't stay at low levels for very long... a possible rising interest rate environment would be very bad for stocks. Again, many people argue against this position, saying that interest rates will likely stay relatively low for a long time; I wonder whether those people are naive or just overconfident, since interest rates have in the past nearly always been trending, not stagnant. See the chart below:

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Boughton GP Line Chart

Both interest rate levels and PE ratios suggest that today is a very similar time to 3/31/66 in many ways, even though of course much is different, too. You can draw several interesting geo-political parallels, too, if you can remember that far back. Things about the US place in the world, GDP share trends, corporate respect, military involvements, etc.

How to respond to this environment, where stocks might look cheap, but where there is also good [and little appreciated] statistical support for this being the very worst possible time to invest in stocks? Our firm is increasing weightings in international stocks, income-focused alternatives, and traditional long-short hedge funds

Source: Analyzing Corporate Profits: Will History Repeat Itself?