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Equities remain very cheap based on corporate profits

With today's final revision to fourth quarter GDP we also received information on corporate profits, and they were strong. The top chart compares the true economic profits of all U.S. corporations (after tax, and with adjustments for inventory valuation and capital consumption) to nominal GDP. Note that profits doubled from 1998 to 2009, yet the S&P 500 index today is still lower than it was at the end of 1998. The second chart shows profits as a percent of GDP; note that profits by this measure have almost recovered all the losses that occurred in late 2008. By any standard, the corporate profits picture is very bright.

The third chart is my variation on Art Laffer's equity valuation model, which in turn is a variation on the "Fed Model" of corporate valuation. It uses the after-tax corporate profits measure from the top chart and capitalizes it using the 10-year Treasury yield, and compares that to the market's actual capitalization using a normalized S&P 500 index as a proxy. By this measure, equities continue to be extremely undervalued. Another way of looking at this is that the market is discounting current profits using an 8% 10-yr Treasury yield, or a 50% drop in corporate profits from here. Simply put, according to this model the market is priced to some very awful assumptions.

The last chart simply extends the time horizon of the third chart, to encompass all the available data on this measure of corporate profits. If nothing else, it shows that capitalized profits and market cap track each other quite closely over a very long period. The model revealed that the market was significantly overpriced in 2000, and it has been pointing to a gigantic undervaluation of the market since late 2008. I would expect the current undervaluation to shrink by way of rising Treasury yields and rising equity prices. Leaving profits constant, the red and blue line in this last chart could close their gap with, for example, 10-yr yields at 5.5% and the S&P 500 up 50% from current levels. Both sound reasonable to me.

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