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Corporate profits look very strong

With the final revision to Q1/10 GDP released today, we see a nice upward revision to corporate profits, which were already pretty strong to begin with. In the top chart the blue line reflects total after-tax corporate profits, while the red line shows the profits of nonfinancial domestic corporations. Note how the latter has surged by 83% since the low of late 2008; this means that your average home-grown company's profits have nearly doubled since the depths of the recent recession. That the red line has risen proportionately more than the blue means that the profits of financial corporations have lagged, which is not surprising given all the problems in the banking sector.

Pessimists would be quick to note that profits are now almost as high, relative to GDP, as they have ever been, and thus there is nowhere to go in the future but down. I would counter that by noting that corporate profits have doubled since 1998, long before the equity market reached bubble territory, but equity valuations as measured by the S&P 500 have not risen at all in the intervening years on net. I think this makes a strong case for stocks being undervalued today, depressed by, among other things, a) fears of a double-dip recession, b) anticipated future tax hikes, c) increased government regulation, and d) worries over how the Fed is going to unwind $1 trillion of monetary stimulus. It's not a secret that there are all sorts of problems out there, and there is no shortage of things to worry about these days. These numbers suggest that the market has already discounted a lot of problems, if not all of them. So if anything starts to move in a positive direction (e.g., the November election results in a big mandate to cut spending and avoid tax hikes), then the market should have plenty of upside potential.

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