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Corporate profits are still very strong

My wife thinks I'm insane to be pecking at the computer when a view like this is right outside our door, but I thought the news on corporate profits released today was worth a post.

Along with the revisions to Q3/11 GDP—which were not significant—we now have the first estimate of 3rd quarter corporate profits, and they continue to surprise on the upside. After-tax corporate profits increased 11.4% in the year ending Sep. '11. 

Relative to GDP, corporate profits are now at a new all-time high of 10.3%. This recovery may have been the most tepid on record, but the surge in corporate profits is unprecedented. This is grist for a lot of philosophizing, which I might attempt at a later date.

The chart above is my attempt to create a PE ratio using the S&P 500 index as a proxy for the value of all corporate equities, and the after-tax NIPA profits figure as the earnings. The level of the ratio is not as important as the relative changes that occur, since I'm using a normalized figure for the S&P 500 index. By this measure, equities have never been cheaper; the last time this PE ratio was this low was in the late 1970s and early 1980s, times which would have been fabulous buys with the benefit of hindsight. Extremely strong profits coupled with historically low PE ratios is a strong sign that investors are extraordinarily pessimistic about the future. This market is most definitely not suffering from an excess of enthusiasm. On the contrary, the pessimism is so thick you could cut it with a knife.

This chart compares NIPA profits to S&P 500 reported profits. Not surprisingly, both follow the same pattern over time, but NIPA profits appear to lead reported profits, and are also more stable. That would suggest we still have more good news to come for reported corporate earnings.

This chart compares total corporate profits to the profits of nonfinancial domestic corporate profits. Since both lines have tracked each other very well over long periods, there is no a priori reason to think that foreign-source profits today are unusually large, or that the profits of financial companies are out of line with historical experience.

All in all, some very welcome good news on profits, even if Q3/11 GDP was revised down a touch. Since the weather here in Maui is fabulous and the views are spectacular, it's time to go for a walk and enjoy the sights. With corporate profits still so strong, the world can't be a very dangerous place.

UPDATE: The fact that profits are up so much but equity prices are not is simply the market's way of saying that profits are likely to decline significantly in the future. In other words, one could argue that the market is priced to the expectation that profits will be mean-reverting in relation to GDP; instead of profits being 10% of GDP, the market expects profits to be 6% of GDP at some point in the future. Either nominal profits will decline or they will cease to grow as GDP expands. So if profits do fall or grow at a very slow rate in the years to come, that won't necessarily be bad for equity prices, because the market already expects that to happen. In a sense, profits must perform miserably just to validate the market's expectations. Profits could well prove to be mean-reverting, but if that occurs in an environment of relatively fast GDP growth and a benign fiscal and regulatory climate, then equity prices could advance significantly in the years to come.

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