Corporate Profits Are Still Healthy

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The collapse of oil prices that began over two years took a big bit out of corporate profits, but now that oil prices have been relatively stable for the past year or so, corporate profits are rebounding. Profits are still below their previous highs, both nominally and relative to GDP, but they are still healthy from an historical perspective. Using the measure of corporate profits that comes from the National Income and Product Accounts as the E, and the S&P 500 index as the P, P/E ratios are only modestly above their long-term average.

The chart above shows after-tax corporate profits (for all corporations), adjusted for capital consumption allowances and inventory valuation. This is considered to be the best measure of "economic" profits over time, as distinct from FASB profits. Note that profits are up over 13% in the past nine months, and were only briefly higher in the period just before oil prices collapsed. Note also that profits have tripled in the past 16 years, over which period the S&P 500 rose only about 50%.

The chart above compares this same measure of profits to nominal GDP. For the past 70 years or so, profits have averaged just over 6% of GDP. Today they stand at 8.5%. (The y-axes of the above graph are set so that the red and blue lines intersect when profits are equal to 5% of GDP.) For years, stock market skeptics have argued that profits were mean-reverting, and would inevitably fall from the 8-9% levels relative to GDP that were achieved in late 2009 and early 2010. That has not happened.

I've theorized for years that profits can sustain a level relative to GDP that is higher than what we saw prior to the late 1990s because of globalization: U.S. firms are now able to address a market that is significantly and permanently larger than it was prior to the mid-1990s. As an example, consider that since the mid-1990s, U.S. international trade has roughly doubled in size relative to GDP, from 6-7% to almost 15%.

If NIPA profits are superior to FASB profits, as Art Laffer has argued for decades, then it makes sense to use NIPA profits to calculate P/E ratios. The chart above does just that, using NIPA profits as the E, and the S&P 500 index as the P. (The S&P 500 index is arguably a reliable proxy for the valuation of all U.S. corporations.) I've normalized the numbers so that the long-term average of this series is equal to the long-term average of P/E ratios as calculated by Bloomberg, using adjusted FASB profits. Here we see that P/E ratios are only slightly above average (17.5 vs. 16.5).

At the very least, these charts support the notion that stocks are not egregiously overvalued, as many continue to argue.