Corporate profits

Are corporate profits a bubble ready to burst?

US corporate after-tax profit for the first quarter of 2012 was the highest since 1947 at $1.671 billion. It was also the highest as a percentage of GDP at 10.8%. This article examines whether corporate earnings have peaked and the implications for stock markets.

The chart below shows after-tax earnings for US corporations from 1947 to the first quarter of 2012.

Click to enlarge the images.

After a sharp decline in profits during the 2009-2010 recession, corporate profits hit an all-time high. It should be noted that corporate profits are much higher than the period 2005-07, which was a period of significant global boom.

The following chart shows after-tax corporate profit as a percentage of GDP from 1947 to the first quarter of 2012.

After-tax business profit as a percentage of GDP

Corporate profit as a percentage of GDP was 10.8% in the first quarter of 2012 (the highest since 1947). This is well above the 6.2% average for the reporting period (1947 to Q1 2012).

These charts point to a crucial question: are corporate earnings sustainable at higher levels or have they peaked and will they begin to decline?

Answering this question is important for two reasons. First, growth in the United States has been largely driven by the private sector. The public sector lagged, as shown in the chart below.

private sector growth versus public sector growth

Thus, if corporate performance were to deteriorate over the long term, GDP growth in the United States would be severely impacted.

The second important reason for this analysis is to understand the probable trend of equity markets in the medium and long term.

The answer to this question can be divided into two parts:

  1. In the near term, I expect corporate earnings to decline from the peak.
  2. In the medium to long term, I expect corporate earnings stretch much higher.

The short-term expectation is relatively easy to explain in the context of a global slowdown. Investors have already seen some companies miss estimates and others warn about future growth and earnings prospects.

I discussed the likelihood of a global recession in one of my previous articles. A slowdown in the coming quarters should affect business growth. The critical point here is a global slowdownand not just a slowdown in the United States

The US corporate sector has global revenue diversification and a slowdown in the US may be partially offset by a focus on high growth markets. However, a global slowdown would even impact the growth and profitability of well-diversified (geographically) companies.

It’s hard to talk about the number of quarters in which corporate profits could decline. However, I am relatively sure that the next three to four quarters will not be very pleasant.

Over the long term, I can say with some confidence that the US corporate sector will do well in terms of growth and profitability. I personally have a penchant for the private sector because of its dynamism and its spirit of innovation.

Before discussing investment strategy, I would like to introduce another chart to discuss another aspect of the US corporate sector. The chart below shows GDP growth and corporate profit growth over the past 60 years.

GDP Growth vs Corporate Profit Growth

As the chart shows, GDP growth in the United States paralleled growth in corporate profits from 1948 until the mid-1980s. After that, GDP growth sublimated while growth in corporate earnings remain relatively robust. The point I’m trying to make here is that the business sector has maintained its growth (even in times of low GDP growth) through innovation and global diversification.

In the long term, global diversification will be the main driver of revenue and profits for American companies. I am optimistic about the long-term prospects of emerging Asia and Africa, as I discussed in one of my previous articles.

American companies should therefore benefit from this growth. I’m not saying that companies that are relatively less globally diversified will fare badly. However, robust growth will only come from a greater presence of US companies in relatively high-growth markets.

Investment strategy

From an investment perspective, an ideal strategy is to wait for a stock market correction over the next few months as markets anticipate a global downturn and slowing earnings. I wouldn’t be surprised to see a 10-15% correction in the index over the next two to three months.

In the event of a correction, investors may consider long-term exposure to quality stocks. Again, in my view, investment should focus on global commodity giants and other companies with a globally diversified revenue stream.

I mentioned the commodity giants since the commodity bull market is far from over. Additionally, a slowdown in China and India provides an opportunity to accumulate commodity stocks at attractive valuations.

Below are some specific investment options that I find attractive during a correction:

SPDR S&P 500 ETF (SPY): The ETF provides investors with investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.

The Vanguard Energy ETF (VDE): The ETF will offer investors exposure to the commodities (energy) sector. The fund has a low expense ratio of 0.19 and had 43% exposure to integrated oil and gas companies, 26.4% exposure to oil and gas exploration and production, and 16. 6% to oil and gas equipment and services.

Vanguard Materials ETF (VAW): The ETF would fall under the broad natural resources category and offer investors exposure to industrial commodities, agricultural commodities, chemicals and gold. The ETF has an expense ratio of 0.19% and an SEC yield of 2.16%. Some of the ETF’s largest holdings include Monsanto (MON), Freeport-McMoRan Copper & Gold (FCX) and Newmont Mining (NEM).

Vanguard Long-Term Corporate Bond ETF (VCLT): From a debt investing perspective, investors may consider exposure to VCLT, which is a better long-term investment than long-term Treasuries (in my opinion). The ETF has exposure to high quality companies with a very low expense ratio of 0.14% and a good SEC yield of 4.3%.

Disclosure: I have no positions in the stocks mentioned and do not plan to initiate any positions in the next 72 hours.