Q4 GDP Stats Suggest Market Not Overpriced Nor Overinflated

 |  Includes: AGG, DIA, SPY
by: Calafia Beach Pundit
(Click to enlarge)

(Click to enlarge)

With today's release of Q4 GDP stats, we have our first look at corporate profits for the quarter, and once again they were higher. After tax corporate profits rose 13.7% last year, and now stand at 8.4% of GDP, substantially higher than the 6% average ratio of profits to GDP since the data have been collected. Since 1999, when the S&P 500 first reached its current level of 1320, corporate profits have more than doubled. By that metric stocks have lost half their valuation over the intervening years.

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The chart above creates a PE ratio for the S&P 500 by using after tax corporate profits from the National Income and Product Accounts as the earnings. Here we see that PE ratios, currently about 12, are substantially lower than the long-term average of 15.7. All of this suggests that at the very least, equities are not over-priced, inflated, or in bubble territory. Equities are cheap by these historical metrics, which implies that the equity market is priced to some very conservative and/or pessimistic assumptions. Ditto for the bond market, where historically low levels of Treasury yields and expectations for Fed tightening are consistent with a view that the economy will grow very slowly and inflation will remain low for a considerable length of time.

Profits have been very strong in the this recovery, but the market is taking nothing for granted. Equities are essentially priced to the expectation that profits will decline by 25% relative to GDP in coming years, which would take the profits/GDP ratio back to its long-term average of 6%. That could well happen, and it makes sense to think that there is a mean-reversion behavior inherent in profits and GDP. But again, it implies that the market is most definitely not over-priced or artificially inflated.