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More good news on corporate profits

Here's a 50-year history of corporate profits (adjusted, after-tax) as a percent of GDP. Besides noting the obvious, that profits relative to GDP have improved sharply this year and are above average, I think it's very important to note the following: Profits relative to GDP fell during the 1968-80 period, and this period also saw miserable performance from the stock market. Then profits rose relative to GDP from 1980 through 1998, and this marked one of the great bull markets in history. Profits fell relative to GDP from 1998 through 2002, and the stock market collapsed. Profits have risen sharply this year relative to GDP, and stocks have soared. I don't think these observations are coincidences. I do see a legitimate rationale for equity market gains.

This next chart shows my calculation of a PE ratio for the stock market, using NIPA after-tax profits as the source for the E, and the S&P 500 index (normalized) as the source for the P. Note that the ratio was ridiculously high just before the stock market collapsed in 2000-2002, while the current PE ratio is quite low by historical standards, suggesting that the market is quite conservatively valued. Again, another reason to be bullish on the prospect for equities.

Alert readers would be pointing out at this juncture that PE ratios calculated using GAAP profits are significantly higher today (north of 20) than this chart is suggesting. The reason for this is that GAAP profits are extremely depressed relative to NIPA profits, as this next chart shows. GAAP profits are traditionally much more volatile than NIPA profits due to the vagaries of corporate accounting practices, whereas NIPA profits are based on IRS data and adjusted to reflect "economic" profits. This chart further suggests that we are likely to see some exceptionally strong gains in GAAP reported profits in the next year or so, since NIPA profits generally lead GAAP profits.

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