Corporate profits

Corporate earnings remain strong | Looking for Alpha

Today’s first revision to second quarter 2013 GDP growth (which was revised upwards from 1.7% to 2.5%) led to the first glimpse of corporate earnings for the quarter, and the news has been great. After-tax corporate profits hit a new record high of $1.68 trillion, up 7% from a year ago. It’s actually in the realm of wonder considering that this measure of earnings (arguably the best measure of “true” economic earnings) is up 218% since the first quarter of 2000 (when the S&P 500 peaked for the year), but the S&P 500 has only risen 7.5% since then. Looking back, we know stocks were seriously overvalued in 2000, but that can hardly be the case today.

Note how strong corporate earnings have been since 2000, despite the current slow recovery (in fact the weakest recovery in history).

The chart above provides a long-term perspective on the behavior of corporate earnings relative to nominal GDP.

Relative to nominal GDP, corporate profits are now just below an all-time high.

Using the methodology explained in my article last week, the chart above shows the stock market P/E ratio using the NIPA measure of after-tax corporate earnings instead of 12-month earnings. This suggests that stocks are currently trading around 25% below their historical average P/E. This is also surprising since P/E ratios tend to follow interest rates inversely (i.e. P/E ratios tend to be low when market interest rates are high, and vice versa).

Ten-year Treasury yields are still extremely low from a historical perspective, but P/E ratios are quite low from the same perspective. This suggests that the market has little confidence in the ability of corporate earnings to sustain current levels. Instead, it appears the market is being priced on the expectation that corporate earnings will “return” to their long-term average of 6% to 6.5% of GDP.

But like I said before, it is not necessarily true that corporate profits should or are likely to return to a historical average relative to GDP. American companies are increasingly operating in a growing global economy and market. As the chart above suggests, corporate earnings relative to global GDP are still quite close to their long-term average. Thus, there may be little reason to believe that earnings need to decline significantly or are at unsustainable levels today.

NIPA earnings and reported earnings tend to track each other over time, with NIPA earnings tending to be at the top of trailing earnings. This suggests that reported earnings should continue to grow. At the very least, corporate earnings news provides strong support for the current level of stock valuations. From a bullish perspective, stocks appear to have much more upside potential and could be considered significantly undervalued.