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Corporate profits are still strong, and markets are still skeptical

With yesterday's release of revisions to first quarter GDP we got a first look at corporate profits. Although after-tax profits slipped 2% from the prior quarter, they grew 6.1% over the past year and remain very high relative to nominal GDP. Despite the impressive performance of profits in recent years, the market remains skeptical about the future.

The two charts above compare the National Income and Product Accounts measure of after-tax corporate profits to nominal GDP over different time horizons. Although the growth of corporate profits has slowed in recent years, profits are at or near all-time high levels, both nominally and relative to GDP, with the latter comparison shown in the chart below. In the past 55 years we have never seen such a strong period of profits growth as we have in this recovery.  

The fact that corporate profits have tended to track nominal GDP over time is not unusual, but the degree to which profits have outperformed nominal GDP in recent years is exceptional. I've argued for a long time that the market looks at the first chart above and sees a compelling case for corporate profits to revert to their long-term mean (just above 6% of nominal GDP). That would of course imply either a huge decline in profits in the next few years, or an extended period of flat profits, and that helps explain why the market is reluctant to embrace equities. As the second chart above shows, equity flows have been strongly negative for the past six years, even as corporate profits have surged. In short, the market has been behaving as if it were highly skeptical of the durability of corporate profits.

The charts above represent two different ways to judge the valuation of the equity market, both using a ratio of equity prices to earnings. To construct these PE ratios I've used the S&P 500 index as the basis for the "P." In the first chart I've used the NIPA measure of after-tax corporate profits for the "E", and in the second chart I've used the traditional measure of 4-quarter trailing earnings per share for the "E." Both show similar patterns, and between the two of them they suggest that equity valuations are either very attractive (i.e., very low relative to the long-term average), or about fairly valued (i.e., approximately equal to their long-term average). One thing for sure: there is no sign here of any irrational exuberance. 

The above chart compares these two measures of corporate profits. Again, very similar, though NIPA profits have grown somewhat faster than S&P 500 earnings per share in the past 30 years and they have been less volatile. I note that NIPA profits tend to lead EPS, and one reason is that NIPA profits are quarterly annualized numbers whereas EPS are 4-quarter trailing profits, so NIPA profits are more contemporaneous. Another reason for the different levels of the two profits measures is that NIPA profits are based on IRS returns, and do not include things such as write-offs that can depress reported EPS. The recent growth of profits by either measure is modest, and it's tempting to think profits might "roll over" in the next year or two. That's what I think the market is already pricing in: a period of very weak growth or the possibility of a recession.

As a counterpoint to the view that profits are so high relative to GDP that they are very likely to revert to the mean, I offer the chart above. This shows that corporate profits are not very high at all when compared to global GDP. Global GDP has grown much faster than U.S. GDP in the past decade, and global sales have become an increasingly important source for the profits of U.S. corporations. So while profits look unsustainably high relative to U.S. GDP, it may simply be the case that, thanks to strong global growth which has greatly expanded the market for U.S.-based corporations, profits are going to move to a new high level relative to U.S. GDP—in other words, the mean is going to shift up permanently. The world has undergone fundamental and significant changes in the past decade, so U.S.-based metrics have become less relevant.

The chart above compares the earnings yield on the S&P 500 (the inverse of the PE ratio) to the real yield on 5-yr TIPS (inverted). The point here is to tie together the messages embedded in stock and bond prices. I think these two series track each other over time because they both reflect the market's confidence in the future health of the economy. When real yields were very high in the late 1990s, equity yields were very low; both were consistent with a market that had a high degree of confidence in the ability of the economy to grow and corporate profits to prosper. Currently, real yields are very low (though they have jumped quite a bit in the past two months) because the market worries that economic growth will be weak, and earnings yields are relatively high because the market worries that corporate profits growth will be disappointing. In short, both tell the same story: the market today is not optimistic at all about what the future holds in store for profits or for economic growth.

The chart above is another method of judging the valuation of equities. It subtracts the 10-yr Treasury yield from the earnings yield of the S&P 500. That gives you the extra yield that investors demand in order to hold equities instead of the safer 10-yr Treasury. The higher the equity risk premium, the riskier stocks are perceived to be. As the chart suggests, the market believes that equities are unusually risky at this time. That fits with my observations above that the market appears to be very worried that earnings are headed for an extended period of weakness.

Now, the market may well prove to be correct, and corporate profits and the economy could tank in the next few years. But to a great extent, that is what the market is priced to. If profits fail to tank and the economy fails to suffer another recession—even if the economy only manages to grow at 2% a year—the market may have to reprice upwards because the future will not turn out to be as bad as is currently expected. Avoiding a recession is all that matters. Long-time readers will know that this is the same story I've been telling for the past four years. The market has consistently underestimated the economy and corporate profits; the rally in equity prices has therefore been a reluctant rally, climbing walls of worry. I don't see a reason to think that anything has changed.

QE3 proves the Fed is powerless to manipulate interest rates

If the Fed bought three quarters of the new issuance of Treasury securities over an 8-month period, with a focus on longer maturities, the 10-yr Treasury yield would almost certainly fall, right? And if the Fed bought all the new issuance of MBS over an 8-month period, increasing its share of home mortgages by over 40% in the process, yields on MBS would almost certainly fall, right?

Wrong. The Fed has indeed been a huge buyer of Treasuries and MBS since last September, but Treasury yields and MBS yields have moved significantly higher, not lower.

What we've witnessed over the past 8 months—the duration so far of the Fed's Quantitative Easing Part 3—is almost a laboratory experiment designed to discover which is the more important determinant of longer-term interest rates: the market's willingness to hold the existing stock of bonds, or the actions of a very large purchaser of bonds on the margin (i.e., the stock vs. flow argument).

It's my impression that most market participants have been persuaded by the flow argument: namely, that the Fed's massive QE3 purchases have artificially depressed market interest rates. After all, that's been the Fed's stated intention: to buy lots of bonds in order to depress interest rates and thereby stimulate borrowing and economic activity. This line of reasoning says that the fact that 10-yr Treasury yields averaged an exceptionally low 1.75% over the past year has nothing to do with the market's view of inflation or economic growth; Treasury yields have in fact become meaningless inputs to valuation models and offer no insight into market and economic fundamentals, other than as a distorting influence.

I've argued to the contrary on many occasions over the years. I believe that interest rates are determined by the market's willingness to hold the existing stock of bonds, especially since Fed purchases on the margin represent only a small fraction of the existing stock. I think the Fed can only influence yields to the extent that the market's view of the economy is similar to the Fed's. If both expect the economy to be very weak, yields will be low, and prices will behave as if Fed purchases of bonds to stimulate the economy are in fact achieving their stated objective. But if the market thinks the economy is improving and/or inflation is rising, then no amount of Fed purchases will be able to keep yields from rising. That's the situation today, and it's been unfolding (in fits and starts) almost from the day QE3 began.

Since last September, when the Fed announced it would begin buying $40 billion per month of MBS, the Fed's holdings of MBS have increased by about $330 billion, and that means the Fed has essentially purchased all of the new MBS issuance since last September. As the chart above shows, the Fed now owns over 12% of all home mortgages, up from less than 9% at the end of last September. Yet despite these massive purchases, the yields on MBS have increased by over 100 bps!

When QE3 was first announced in late September, MBS spreads briefly plunged to almost zero as market participants attempted to "front-run" Fed purchases. But since then they have widened to almost 80 bps, not too far from their 30-year historical median of 114 bps. The MBS market was briefly distorted by QE3, but it is now behaving more normally.

Since last September, the Fed has been buying about $45 billion of Treasuries notes and bonds per month, and that adds up to almost 75% of the federal budget deficit over the same period. These purchases have boosted the Fed's holdings of marketable Treasuries from 15.3% of marketable Treasuries to about 16.5%, as the chart above shows, but that is still a relatively small fraction of the outstanding stock of Treasuries. Despite the Fed's massive purchases, 10-yr Treasury yields are up over 50 bps since last September. I would further note that if Fed purchases of Treasuries were a significant factor in driving yields, then the blue and red lines in the above chart should have a strong tendency to move in opposite directions (e.g., large purchases would increase the Fed's share of marketable Treasuries and would tend to depress yields). But for most of the past 10 years these lines have tended to move together; they only moved in opposite directions in the second quarter of 2008 and 2011.

As I explained a few weeks ago, when central bank purchases produce counter-intuitive results, it's a good indication that the economy is perking up. Yesterday I made that same case in reference to the even bigger increase we have seen in real yields on TIPS. Higher real and nominal yields are telling us that the market's outlook for economic growth is improving, while at the same time inflation expectations are moderating. If Fed purchases were artificially pumping up the economy, then we should have seen rising inflation expectations, lower real yields, and higher gold prices.

Of course, many observers will be quick to object that yields are up because the Fed has been actively dropping hints that it may taper its QE3 purchases somewhat earlier than expected, and this has caught the market by surprise. But the fact remains that the Fed is still a large purchaser of Treasuries and MBS, and their prices are still falling. My interpretation is that the market hears the Fed hints of an early QE3 tapering and concludes that it is reasonable for the Fed to end QE3 sooner than expected, because the economy outlook is improving, however marginal that improvement might be. As I've mentioned quite a few times before, avoiding a recession is all that matters for investors when short-term interest rates are virtually zero.

To sum up, I believe the history of QE3 shows us that the Fed cannot manipulate longer-term interest rates. Yields are fundamentally determined by the market's perception of the prospects for inflation and economic growth, not by Fed purchases of Treasuries and MBS.

The biggest change on the margin: real yields

Since the beginning of April, real yields have soared, in what is now the biggest change on the margin to be found in the stock and bond markets.

The chart above shows the real yield on 5-yr TIPS, which is up 80 bps since early last month. This measure of real yields is now at its highest level since early 2012. At the very least, a big increase in real yields on TIPS (which is the flip side of a big decline in TIPS prices) is consistent with a big decline in the demand for the inflation-hedging properties of TIPS.

Real yields on 10-yr TIPS are up 60 bps from their early-April levels. This is an across-the-board increase in real yields.

As the above chart suggests, higher real yields on TIPS are likely driven by improving expectations of future economic growth. The rise in real yields also correlates to increasing hints from the FOMC that an end to Quantitative Easing may be coming sooner than the market had expected. But if the Fed is likely to move sooner than expected, the underlying reason is most likely an improving economy.

As the above chart shows, gold prices have dropped rather precipitously since early April. Declining gold prices likely reflect reduced concerns about the inflationary potential of monetary policy, and they could also reflect reduced concerns about the possibility of another recession or economic collapse. Gold, in other words, is consistent with the message of nominal and real yields.

The chart above shows the difference between the nominal yield on 5-yr Treasuries and the real yield on 5-yr TIPS, otherwise known as the market's expected annual inflation rate over the next 5 years. Expected inflation has fallen by about 50 bps since early April, and most of that decline can be explained by a rise in real yields, since nominal yields are up only 25 bps or so.

To summarize, there have been big changes in the bond market in recent months that point to 1) improving expectations for real economic growth, and 2) somewhat lower inflation expectations. Both of these, in turn, are consistent with the 7% rise in the S&P 500 since early April. These are all healthy developments. Perhaps more importantly, these changes are NOT consistent with the view that the equity market is being pumped up by easy money. If easy money were the driving force, we would be seeing higher gold prices and lower real yields.

The housing recovery is real

A variety of surveys show that housing prices on average rose 10-14% in the year ended last March. Nominal housing prices are now at a post-recession high, after being relatively flat for the past four years. Over the same period, an index of the stocks of major home builders has risen 245%, housing starts are up 78%, and residential building permits have almost doubled. The conclusion is obvious: the housing market recovery is real and robust.

The two surveys of housing prices shown in the chart above use different methodologies but arrive at similar results: prices are up between 10 and 14% over the past year, and prices are now at a post-recession high. (The Case Shiller index tracks the sale price of the same houses over time, and reports the average price of homes sold, and the Radar Logic index tracks the average cost per square foot of homes sold. For this chart I have used the seasonally adjusted Case Shiller index and the nonseasonally adjusted Radar Logic index.)

Adjusted for inflation, housing prices fell over 40% from their early-2006 high to their early-2012 low, according to this measure of prices in 20 major metropolitan markets. That's a huge downward adjustment—by far the biggest in modern times—but it was necessary to clear the a very large excess housing inventory.

The chart above covers a longer time span, but only 10 major metropolitan markets. The decline in inflation-adjusted housing prices from 2006 to 2012 was almost identical to the decline in the prior chart. Prices today are about 17% higher in inflation-adjusted terms than they were in 1989. However, 30-yr fixed mortgage rates were over 9% back then, whereas they are only 3.75% today. Thus, the monthly cost of buying the same house today is about 60% less than it was in 1989. Housing has never been more affordable for the average family than it is today, as shown in the second chart above.

Home builders' stock prices are up 245% from their recession-era lows, as the above chart shows.

This index of homebuilders' market sentiment (builder perceptions of current single-family home sales and sales expectations for the next six months) has improved dramatically over the past year or so, but it is still under 50, the point at which just as many builders rate conditions as "good" as do "poor." In other words, even though there has been a dramatic improvement in the housing market, there is no sign of excessive optimism among major home builders.

Consumer confidence has likewise improved dramatically from its recession lows, but confidence is still at levels that were consistent with prior recessions. We are still far from reaching conditions which might be considered "optimistic." Skepticism and caution are still widespread, and that means that there is plenty of room for the housing market to improve in coming years.