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More on corporate profits

This extends my posts of yesterday on the subject of corporate profits. This chart shows total corporate profits alongside profits from nonfinancial business corporations. Note that the two vertical scales are proportionately calibrated, with nonfinancial domestic profits just about half of total profits. The chart should make it clear that financial sector profits (and losses) have not greatly distorted the total profits picture on balance.

It's interesting to note the huge decline in nonfinancial domestic profits in the wake of the relatively mild 2001 recession, and the far milder drop in those profits during the much more severe 2008-09 recession. I don't have a good explanation for that, but would welcome suggestions.

The above chart compares NIPA profits (total after-tax economic profits of U.S. corporations) with reported operating profits of major corporations. Note how much more stable NIPA profits are than operating profits. I also detect a tendency for NIPA profits to lead operating profits. One reason for that, of course, is that the operating profits ratio is based on trailing four-quarter profits, whereas NIPA profits represent a seasonally-adjusted annual rate for each quarter. We could see some pretty impressive performance in this series over the next year as operating profits catch up to the stronger NIPA profits.

CDS update

Credit spreads are very important indicators to watch, so once again here is an updated version of generic credit default swaps. Spreads continue to slowly tighten, which is good, but they remain significantly higher than they were before the subprime crisis exploded. The bond market is still very cautious (and that is consistent with my take on equity valuation), and it's obvious we aren't completely out of the woods yet. But we are making progress, and that's what's important.

Using NIPA profits to calculate PE ratios

This post expands on the previous post. The chart above uses the normalized value of the S&P 500 index as the "P" and after-tax corporate profits from the National Income and Products Accounts as the "E", in order to calculate a PE ratio. In the previous post, I was examining equity valuations using a combination of profits, current equity prices, and interest rates. In this post, I leave out interest rates; that makes the degree of undervaluation much less, but it ends up telling the same story. Note that this very simple model of equity valuation correctly identified how cheap stocks were throughout the 1980-1998 period, and correctly flagged the grievous overvaluation of stocks in 2000.

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.

Slow M2 growth not necessarily bad

From today's money supply data, we see that M2 has grown only 0.9% in the past year. Since 1960 at least, M2 growth was only lower than this in late 1994 and early 1995. Is this a cause for concern, or a portent of deflation? Not necessarily. Recall that in early 1995, almost at precisely the same time that M2 growth approached zero, the stock market began a powerful rally that lasted through early 2000.

As I've discussed several times before, slow money growth that comes on the heels of unusually fast money growth typically reflects a decline in the demand for money, not a tightening of monetary policy. This decline in money demand goes hand in hand with a recovery in confidence and with a recovering economy. People tend to accumulate money balances when uncertainty is high, then spend the money as uncertainty is gradually replaced by confidence and eventually optimism. I think this is one of those times.

So rather than fear slow money growth, we should welcome it as a sign that people are again deciding to put their money to work, rather than hoarding it. By spending their M2 balances, the public is helping to get the economy back on its feet, and at the same time minimizing the risk of deflation.

UPDATE: Mark Perry and I have been having a friendly back-and-forth over the issue of whether my call for rising inflation is consistent with the pronounced slowdown in M2 growth shown in the above chart. As partial support for my view, I submit the following chart, which simply compares M2 growth and growth in the consumer price index. I would note that the two lines display a substantial degree of negative correlation, which is to say that inflation has a tendency to rise as money growth declines, and vice versa. I think this is consistent with what I have described above, namely, that changes in M2 growth reflect changes in money demand, and this can have important implications for economic growth and inflation. You can see his latest commentary on M2 growth here.

What people think about Congress

Shortly before last weekend's vote on the healthcare bill, the PEW Research Center asked some 749 people for the one word that best described their view of Congress. This graphic shows the 19 top choices:

Very interesting that "Of those offering a response, 86 percent said something negative while just 4 percent gave a positive one-word description." Even harsher words come to my mind.

HT: Coyote Blog

Higher Treasury yields, please

At 3.91% as I write this, the yield on 10-year Treasury bonds is only 4 bps lower than its 2009 high which was recorded last June. That high, in turn, occurred about the time that the market began to sense that the economy was emerging from the recession that began in early 2008. I continue to believe that yields on the 10-yr T-bond serve as an excellent gauge of the market's expectations for growth in the U.S. economy. It looks to me like the economy is capable of 3-4% growth, so if the evidence continues to accumulate in support of that, I would fully expect 10-yr yields to rise towards 4.5% or higher. This will not be cause for alarm, it will be simply a confirmation of improved growth expectations, and as such should pose no risk to the stock market.

Long-term trend of commodity prices (2)

To further the discussion on commodity prices, this chart is the inflation-adjusted version of the chart I posted yesterday. Note that the monetary policy regime (which typically alternates between easy and tight) has a significant impact on the behavior of real commodity prices. Easy money not only facilitates commodity speculation using borrowed money, but it also shifts people's preference in favor of tangible assets versus financial assets. In an easy-money world, physical things (real estate, commodities, buildings, structures, offices) become more attractive than financial assets. We tend to build more things when money is easy, and those things require commodities. They become more attractive because their prices tend to rise—tangible assets hold their value (or maybe even make money) when inflation rises, whereas financial assets tend to suffer during inflation because inflation pushes interest rates up, and that depresses the value of financial assets.

Gold is the tangible asset par excellence, because it has proven to hold its value relative to other things over very long periods. But it too can exhibit exaggerated swings as monetary policy alternatives between easy and tight. In addition, in my experience, gold tends to lead other commodities.

So when money is easy, as it is has been and is now, people naturally tend to prefer to buy things instead of financial assets. Stocks have gone up over the past year (about 75% in nominal terms, but only 50% in terms of gold) but they are still very depressed relative to gold from an historical perspective, as the next two charts show. When monetary policy shifts away from its current extremely accommodative posture, as it must at some point, expect gold to decline and stocks to continue to rise.

Unemployment claims continue to decline

After some setbacks in January and February which led the market to question the durability of the recovery that started last summer, unemployment claims have resumed their downtrend. The recovery is still underway, even though progress on the labor front remains painfully slow. Markets have been climbing walls of worry, and each worry—such as the January upturn in claims—has been resolved satisfactorily, allowing equity prices to march slowly higher.

Expect this process to continue. The recovery in equity prices is based primarily on mounting evidence that the economy's recovery is genuine, albeit less than dramatic.

Fear subsides, prices rise (18)

I keep coming back to this chart, which I have shown many times since Nov. '08, because it has done such a good job of explaining both the origins of the great financial panic of '08 and the mechanism for recovery. The whole mess got started because the world feared the collapse of the global banking system. Fear, panic, doubt, uncertainty—all the things that drive the Vix index—spiked to epic levels, and as a result, spending and investment ground to a halt. Then came the Obama panic of early '09, when he called for a trillion dollars of faux-stimulus spending and trillion-dollar deficits for as far as the eye could see, which in turn deflated markets as they contemplated a massive increase in future tax burdens.

As the financial markets gradually healed themselves, with help from the Federal Reserve's (belated) decision to provide essentially unlimited amounts of liquidity to the system, the fears started to dissipate, the spending began to restart, the global economy began to make a comeback, and the price of risky assets began to rise. Although this recovery process has been underway for almost 17 months, we have still not fully recovered, and we are still living under the threat of out-of-control federal spending and its eventual consequences. But we are making progress, and the progress should continue, especially if the electorate in November expresses a strong desire to return to fiscal discipline, as I think it will.

Some pictures are worth a 1,000 words

Long-term trend of commodity prices

I post this at the request of a reader curious to compare the performance of commodity prices and real estate prices in the inflationary 1970s. It should be no surprise to learn that both increased tremendously during that time. Also of interest should be the period from 1980-2004, when commodities were in a flat trend and inflation was low.

Treasury yield update

This is a follow-up to my previous post. Yields on T-bond have jumped about 15 bps in the past several days, in concert with the plunge in swap spreads (the 10-yr swap spread is now down to -9 bps, and has fallen 13 bps since last Friday). This adds weight to the argument that negative swap spreads reflect a decline in demand for Treasuries due to the perception of increased default risk.

I might add that since negative swap rates mean that high-quality corporate yields are now lower than Treasury yields of comparable maturity, this is consistent with the view that the outlook for the economy is improving (because corporate profits are strong and the market's estimate of corporate default risk is down).

Swap spreads collapse

I never thought I would see what this chart is showing. 10-year swap spreads have suddenly, for the first time ever, dropped below zero. They are now -7.25 basis points. Since swap spreads are traditionally a proxy for AA bank credit risk, this means that the market prefers to own 10-yr AA bank debt rather than 10-yr Treasuries. (For my short primer on swap spreads, see here.)

I've several explanations for the recent plunge in swap spreads, but not one that is compelling. The latest one is that corporations are rushing to issue lots of fixed rate debt and then swapping it back to floating; that is equivalent to a surge in demand to receive fixed in a swap transaction, which is itself equivalent to a surge in demand for long-term corporate bonds. But no matter what, the fact that swap yields are lower than Treasury yields can only mean one thing: Treasury bonds are no longer considered to be the most default-free instruments on earth.

Why this should suddenly be the case, however, I don't know. Sure, the healthcare bill will swell the deficit by a huge amount. But we've known for a long time that the federal deficit was going to be gargantuan, and federal unfunded liabilities are ginormous.

I suspect that the imminent end of the Fed's plan to purchase $1.25 trillion of MBS may have something to do with this, but I'm not sure.

But no matter what, the message here is that the market has taken a sudden dislike to Treasuries. And to put it in context, swap spreads have been declining for more than a year. The first phase of this decline was virtuous, since it reflected a return to health for financial markets, which in turn foreshadowed a recovery. But the latest part of the decline has become troubling, since it reflects a loss of confidence in the creditworthiness of the U.S.

Could this be the bond market vigilantes' way of dissing the passage of Obamacare?

Business investment up strongly

Capital goods orders—a good proxy for business investment—rose 1.1% in February, and are up at an annualized rate of 13.4% since their low of last April. As the chart shows, capex is rising at a faster rate in this recovery than it did following the 2001 recession. Business investment is still very depressed, as are a lot of things, but activity seems to be coming back on line at a faster-than-normal clip these days. That's exactly the way the economy should be behaving, according to Milton Friedman's Plucking Model of growth: the deeper the recession, the faster the recovery.

Durable goods orders—a broader classification which includes capital goods plus orders for aircraft and defense-related goods—were also up in February, and have risen at an annualized rate of 13.8% since last April. Both measures reflect a relatively strong investment climate, and, by inference, a reassuring rise in business confidence. All augur well for future growth.

Another look at shipping (3)

The last time I featured this chart was Aug. '09. It's a relatively obscure measure of shipping costs, but it focuses on the North Atlantic, and it compares current shipping rates to the total operating cost of running a ship, including return on equity. Complete info can be found here. For the past year it has contradicted the Baltic shipping index, which has soared. Last August I thought that it had bottomed. As this chart shows (if you have a magnifying glass), I was a little early on my call, but now it does indeed look like it bottomed late last December.

Optimists will view this chart as one more (belated) confirmation that global economic activity is turning up. Pessimists will say that shipping rates are still extremely depressed. I don't know enough about this to take a strong stand, but I take heart from the evidence of positive change on the margin, especially since that fits well with a lot of other indicators of expanding global economic activity (e.g., rising commodity and energy prices, rising equity valuations, declining credit spreads).

Commodities update

Commodity prices continue to rise. This measure, the CRB Raw Industrials Price Index, is now only 4% below its all-time high, which was set in May '08. Note that this index contains no energy prices, and its components (see the bottom part of the chart) are not commodities typically subject to speculative activity, since they are not traded on futures markets. Are the Chinese hoarding hides? Tallow? Wool Tops? Resin? I seriously doubt it. These prices are up because the global economy is growing, demand is strong, and monetary policy is accommodative. Accommodative monetary policy does just that: it accommodates increases in sensitive prices such as these.

The message here bears repeating: deflation is not happening. Deflation is when almost all prices decline. Here we have a basket of industrial commodity prices that have risen 136% from their Nov. '01 lows, or almost 11% per year on average, and they have risen some 60% since the lows of late '08. This, during a time when conventional wisdom (including the inflation models favored by the Fed) has consistently viewed deflation as a major threat, primarily because the economy has been operating with a significant degree of "resource slack." Somebody forgot to tell the commodities market that surging prices were not supposed to be happening.

My takeaway from commodity prices: the risk of deflation is minimal; inflation risk is rising; and the outlook for the economy is much better than the "new normal" crowd would have you believe. And I say that even as I lament the passage of the healthcare bill, which means more government control over the economy, less efficiency, and lower average standards of living than we could have enjoyed if a free market approach to healthcare reform had been used.

Existing home sales update

Existing home sales declined last February, and in the two preceding months, but the news continues to be good. Recent weakness is best seen as "payback" for the burst of sales leading up to November, when people were rushing to take advantage of a government tax credit thought to be expiring. The average number of sales over the past year is still well above the lows of early last year, and the lows of early 2008. Considering that housing prices likely bottomed about a year ago, and that lumber prices have almost doubled in the past year, the evidence that the housing market has stabilized (and is probably turning up, albeit slowly) continues to accumulate.

Commercial real estate outlook brightens

With the release of the January value of Moody's index of commercial real estate prices, we see that prices have increased three months in a row. This looks like a bottom, but it may still be early to call one. Nevertheless, it is encouraging to note that both residential and commercial real estate values have fallen by a similar order of magnitude since their recent highs, and both appear to have hit bottom. It would not be unusual at all for a bottom in prices to occur given a) the degree to which prices have fallen, b) the length of time prices have been weak, c) the emergence of a general economic recovery, d) the presence of extraordinarily accommodative monetary policy for the past 18 months. and e) the fact that mortgage rates are at or very close to all-time lows.

Indeed, if these markets couldn't find a bottom given all of the above conditions, then it would really be time to start worrying.

As further evidence of improving conditions in the commercial mortgage market, I offer this chart of CMBX prices from Markit:

Why a stronger dollar is not a problem (2)

I've been showing this chart off and on for the past year, with an extensive post on the subject last December, which by the way deserves re-reading. What's noteworthy now is the breakdown in the strong negative correlation (~0.95) between the dollar and equities that persisted from Sep. 2008 through Nov. '09. While most pundits viewed the negative correlation as symptomatic of the "carry trade," I thought it had a lot to do with the demand for money. The dollar was on the receiving end of the flight to safety that was precipitated by the financial crisis of '08, and the reversal of that move is what pushed the dollar down and equities up. Dollars that were hoarded in late '08 and early '09 were subsequently released back into circulation, and this helped spark a recovery both here and abroad. A weaker dollar and a stronger economy thus went hand in hand.

What we've seen since last December is a stronger dollar and a stronger equity market. (Note that the chart plots the dollar on an inverted scale.) As I said back in December, this suggests that the economy is improving on its own merits. What's good for the economy is also good for the dollar.  People were very scared a year ago, but that fear has been slowly waning for many months; as fear subsides, the price of risky assets rises, and spending and economic activity improve as well. A stronger economy improves the valuation of the dollar, because a) it improves the expected returns on equities, and b) it means the Fed is less likely to be too easy for too long.

Parenthetically, a good friend asked me over the weekend why the passage of healthcare is being accompanied by higher equities, when it portends more government control of the economy and higher tax burdens. Shouldn't the market be depressed by the passage of a bill that calls for a gigantic expansion of the role of government in the economy? Here are some possible answers: a) the market doesn't believe the healthcare bill will survive the numerous challenges it faces; b) the huge opposition to the bill which was evidenced around the country and in every public opinion poll is a good sign that the era of Big Government has hit the high-water mark; c) the market is still trading at very depressed levels (as I have argued repeatedly); d) the market's rise over the past year has been driven primarily by the huge change between the market's initial expectations and today's reality (i.e., one year ago the market expected a gigantic depression, and instead we find ourselves in a recovery); and e) the healthcare bill won't translate into meaningful changes in policy or taxes for several years at least, so for now the dominant factor driving the equity market remains the underlying improvement in the economy.

If I could summarize all the possible reasons for why the dollar and the equity market have moved higher of late, it would be this: both the dollar and equity valuations remain depressed from an historical perspective, but the dominant changes on the margin have been positive for the economy (a recovery instead of a depression), while the passage and implementation of the healthcare bill is still very much up in the air.

UPDATE: To back up my inclination to view positively the current state of affairs, some quotes from George Will's recent column:

"And everybody praised the Duke, Who this great fight did win."

"But what good came of it at last?"

Quoth little Peterkin.

"Why that I cannot tell," said he, "But 'twas a famous victory"

-- Robert Southey, "The Battle of Blenheim"

Now, perhaps, comes Thermidor.

That was the name of the month in the French Revolutionary calendar in which Robespierre fell. To historians, Thermidor denotes any era of waning political ardor. Congressional Democrats will not soon be herded into other self-wounding votes -- e.g., for a cap-and-trade carbon-rationing scheme as baroque as the health legislation. During the Democrats' health-care monomania, the nation benefited from the benign neglect of the rest of their agenda. Now the nation may benefit from the exhaustion of their appetite for more political risk.

Democrats to America: Drop dead

That's the title of an op-ed by The Washington Examiner published tonight.

Despite more than a year of steadily rising public opposition, manifested in opinion polls and in protest rallies across the country, President Obama, Senate Majority Leader Harry Reid and House Speaker Nancy Pelosi finally rammed through Obamacare late Sunday when House Democrats gave the bill their imprimatur.

The House vote isn’t the end of the national debate on this issue, however, as the Senate still must accept the House changes in the Senate Obamacare bill. Senate Republicans argue that the House reconciliation bill that makes significant changes in the Senate bill violates the Congressional Budget Act of 1974, maintaining that it should be ruled out of order by the Senate parliamentarian for consideration in the upper chamber. That in turn would mean the only bill the president could legally sign would be the original Senate bill, with its massive funding of abortion and the infamous deals used to buy senators’ votes, including the Cornhusker Kickback. At that point, a constitutional crisis of historic magnitude seems inevitable.

Never before in American history has a measure of such importance been imposed on the country by the majority party over the unanimous opposition of the minority.

A fast-track challenge to Obamacare’s constitutionality will likely reach the Supreme Court in coming months. The justices will have multiple issues to consider, including the unprecedented federal mandate that all individuals buy approved health insurance, the undeniable inequity of the many corrupt bargains used to buy votes for the measure, and the banana republic parliamentary tactics used by the Democratic congressional leadership. Whatever the high court’s decision, it won’t be nearly as unpleasant as the verdict many Democrats will hear from their constituents in November.

We have not seen the end of this controversy, not by a long shot. Big Government's days are numbered. If ever there were a reason to believe that politics is shifting to the right, and in a direction more favorable to business, free markets, and individual liberty, it is now.

A clear majority of voters oppose the healthcare bill

Since last June, Rasmussen has been tracking voters' opinion on the healthcare reform bill being voted on today. I haven't seen them use a chart, so the above is my contribution to their work. Opinion was initially divided, but in recent months it has become clear that a majority of voters oppose the bill:

The latest Rasmussen Reports national telephone poll, taken Friday and Saturday nights, shows that 41% of likely voters favor the health care plan. Fifty-four percent (54%) are opposed. These figures have barely budged in recent months.
The House is working furiously to pass this major piece of legislation, despite the fact that it is unanimously opposed by Republicans, and opposed by a majority of voters. This is rather astounding, to put it mildly. Should Pelosi & Co., succeed in passing the bill today, it will be immediately challenged on a number of constitutional fronts, and it will undoubtedly be the focus of the November elections if it is not repealed before then. There is no shortage of pundits that predict major Democratic losses in November, whatever the outcome of today's vote.

Why are they doing this? Several possibilities: they are out of touch with mainstream America; they are elitists and they know better what is good for us than we do; they are hell-bent on expanding the role of government; there are too many corrupt politicians who will vote for anything if given a sufficiently large bribe in the form of goodies for their constituents; the system is broken; all of the above.

The silver lining to this cloud is that healthcare reform will likely prove to be the high-water mark for Big Government.