Wednesday, November 26, 2014

Corporate profits juggernaut continues

In my view, one of the most enduring and extraordinary features of the current business cycle expansion has been the strength of corporate profits. According to the GDP stats released yesterday, third quarter after-tax corporate profits hit a new nominal high of $1.87 trillion, and a new high relative to GDP of 10.3%. So it's no wonder that equities are hitting new highs. Indeed, despite profits hitting all-time record highs, PE ratios today are only slightly above average. Stocks by this measure still look quite attractive.

From 1958 through 2004, after-tax corporate profits averaged about 5.3% of GDP. Since then, and including the profits collapse of the Great Recession, after-tax corporate profits have averaged 8.8% of GDP. As the chart above shows, over the entire period since 1958, corporate profits have averaged about 6% of GDP. For the past 5 years, equity bears have in effect argued that profits were unsustainably high because they had a strong tendency to be mean-reverting to, say, 6% of GDP. Instead, profits have just continued to grow, both nominally and relative to GDP. A pessimistic outlook for corporate profits has essentially been the driving force behind the equity market's gains, because profits have far exceeded expectations. In a sense, the market has been forced higher because profits have been much stronger than expected. 

I argued in an earlier post that profits needn't revert to their historical mean because the world has fundamentally changed. Successful U.S. corporations can now more easily address a far larger market, thanks to globalization:

Global profit margins haven't budged for over 10 years. What's happened is that world GDP has grown much faster than U.S. GDP, and U.S. corporations have cashed in on the boom. Today, a greater portion of corporate profits is coming from overseas, where markets and opportunities are much more dynamic than here at home. Apple can sell iPhones to billions of customers all over the world today, whereas it could only address a much more limited market in the past—primarily the developed countries. Seen from this perspective, there is much less reason to worry about stagnant or declining profits.

But perhaps I'm mixing apples and oranges here, because my source for corporate profits in the first chart in this post is the National Income and Products Accounts (i.e., the GDP stats), instead of the more-commonly referenced reported (GAAP) earnings. As the chart above shows, after-tax corporate profits according to NIPA data have been much stronger over the past decade than profits reported according to GAAP data. I addressed a few reasons for the difference in the behavior of these two measures of profits in a post last year (i.e., changes in accounting standards and changes in taxation regimes). Moreover, NIPA profits are derived from corporate tax returns filed with the IRS, and as such are not impacted by things like "goodwill." Regardless, as the chart above shows, earnings by either measure have been increasing fairly steadily over the past five years, and both are at new highs.

Let's stipulate for the sake of argument that GAAP earnings are what everyone focuses on, and they are the better measure to use when valuing equities. What we get is the chart above, which calculates the PE ratio of the S&P 500. Today it is 18.3, which is only slightly higher than its long-term average of 16.2. If earnings are at new nominal and relative highs, and multiples are only moderately above average, that hardly supports the case that equities are overvalued, as the bears currently believe.

In the chart above I've used NIPA profits instead of GAAP profits to calculate the PE ratio of the S&P 500. (I've normalized the results so that the long-term average is 16, so that it can be compared easily to the prior chart.) Here we see that equity multiples at the end of the third quarter were about average. The real equity market bubble happened in the late 1990s, but it was thoroughly popped.

Another way to value equities is to compare their earnings yield (earnings per share divided by share price—the inverse of the PE ratio) to the yield on risk-free Treasuries. That's shown in the chart above. Although the current equity risk premium is a lot lower than it was several years ago, it is still substantially higher than its long-term average. In order to remain indifferent between holding equities or holding 10-yr Treasuries, investors today are demanding a yield that is more than 300 bps higher than the yield on 10-yr Treasuries. That's solid evidence that the market is still quite risk-averse. In the heady growth days of the 1980s, stocks were so in demand that investors were content to accept an earnings yield that was much lower than the yield on 10-yr Treasuries. If investors were enthusiastic about the outlook for earnings today, earnings yields would be lower relative to Treasury yields.

Yet another comparison that is instructive: comparing the ratio of the S&P 500 index to GDP, and that ratio to the inverse of the level of 10-yr Treasury yields, as shown in the chart above. That the two lines tend to move together is a sign that equity valuations tend to be higher as yields are lower, and vice versa. This fits with the theory that equity prices are the discounted present value of future earnings, so lower discount rates (i.e., Treasury yields) imply higher equity valuations. As the chart suggests, equity pricing is not out of line with Treasury yields. If anything, prices could be higher still. Alternatively, this could be taken as a sign that equities today are priced to the expectation that Treasury yields will move substantially higher (i.e., the market is priced to bad news).

Conclusion: there is still a lot of risk aversion to be found in the pricing of Treasuries and equities. This is a good sign that the equity market is not over-valued and may still be attractive. 

Monday, November 24, 2014

A devastating critique of Piketty

Last April I wrote a post about the problems with Piketty's book, Capital in the Twenty-First Century. Over the weekend I read Deirdre McCloskey's 55-page tour de force review of the book. It's far more than just a critique or a review of the book, it's an education in economics and a dazzling collection of references and observations on politics, society, and economic history. It's densely written, however, so it will require several hours of effort, but I think you'll find it worthwhile.

In one passage, McCloskey the professor gives Piketty a failing grade in basic economics:

Startling evidence of Piketty’s miseducation occurs as early as page 6. He begins by seeming to concede to his neoclassical opponents (he is I repeat a proud Classicist, Ricardo plus Marx). “To be sure, there exists in principle a quite simple economic mechanism that should restore equilibrium to the process [in this case the process of rising prices of oil or urban land leading to a Ricardian Apocalypse]: the mechanism of supply and demand. If the supply of any good is insufficient, and its price is too high, then demand for that good should decrease, which would lead to a decline in its price.” The (English) words I italicize clearly mix up movement along a demand curve with movement of the entire curve, a first-term error at university. The correct analysis (we tell our first-year, first-term students at about week four) is that if the price is “too high” it is not the whole demand curve that “restores equilibrium” (though the high price in the short run does give people a reason to conserve on oil or urban land with smaller cars and smaller apartments, moving as they in fact do up along their otherwise stationary demand curves), but an eventually outward-moving supply curve. The supply curve moves out because entry is induced by the smell of super-normal profits ...


Friday, November 21, 2014

Why the global gloom?

One popular meme these days is "the global economy is slowing down." China's economy has slowed from double digit growth rates to 7%, Japan has suffered two quarters of negative GDP growth, and the Eurozone economy has grown by less than 1% in the past year. The U.S. economy has barely managed to exceed 2% annual growth for the past five years, and people worry about the future since the Fed seems almost certain to begin raising interest rates within the next 3-6 months. Industrial commodity prices are down almost 10% in the past six months, and oil prices have plunged almost 30% since last June—all (supposedly) signs of weaker demand. Moreover, high-yield credit spreads have risen over 140 bps since June, reflecting a loss of confidence in the future of corporate profits. 

To make matters worse, policymakers seem to have run out of options. Short-term interest rates are near the zero bound in Europe, Japan, and the U.S. Quantitative easing hasn't done much at all to stimulate the U.S. economy, and it's unlikely to be a miracle cure for the Eurozone economy. The Bank of Japan has managed to ease by enough to push the yen down by almost one-third against the dollar, but a hike in Japan's sales tax seems to have swamped any stimulus from stronger exports. Genuine stimulus (e.g., tax reform, tax cuts, and reduced regulatory burdens) is being discussed almost everywhere, but it's not likely to happen any time soon.

A lot of people are probably thinking "If policy can't stimulate, and demand is weakening on the margin, it's time to really start worrying."

I'm not so sure it's time to run for cover. 

One of the most remarkable turnarounds in the global economy in recent years is shown in the chart above. In the past two years, the yen has plunged against the dollar, and the value of Japanese equities has doubled, both in seeming lockstep. Even in dollar terms, the Nikkei 225 is up over 30% in the past two years. It's hard to deny that something big is going on here, even though the Japanese economy shrunk in the six months ending September.

Have you noticed that no one seems to be talking about the "wealth effect" anymore? That's the theory that says an increase in stock prices and/or housing prices can induce consumers to spend more because they have become wealthier. That increased spending has the effect of strengthening the economy, or so the theory goes. That's never made much sense to supply-siders, however. You can't spend your way to prosperity. Prosperity only comes as a result of more work, more investment, and/or more risk taking. The "wealth effect" theory assumes that stock prices just happen, or that they can be pushed up by easy money. In turn, higher stock prices cause more spending, which grows the economy and validates the higher stock prices.

Not so, in supply side theory. The stock market, like the bond market, is difficult to fool. Easy money doesn't just magically raise stock prices, and higher stock prices don't then stimulate the economy. More likely, stock prices rise as a result of improving economic and financial market fundamentals. Higher stock prices discount rising future earnings. Stock prices are the barometer of the economy's future health, not a by-product of easy money.

So consider the implications of the chart above. It shows that the market capitalization of the world's equity markets has increased over $40 trillion dollars since March 2009, and in the past two years the value of global equities is up about 30%. That's a huge, and welcome increase. Does it mean that consumers are going to be spending double and triple as much because stock prices have almost tripled? No. It means that the expected future cash flows of corporations all over the globe have increased significantly. Consumers likely will be spending more in the future, but only because corporations will be making more and better stuff, hiring more workers, building new plant and equipment, and booking rising profits. The stock market is often able to look across the valley of despair and see a better future on the other side. It's likely that that's the case today.

As the chart above shows, U.S. equities have greatly outpaced their Eurozone counterparts in the past four years. Well, yes, we know that the U.S. economy has been much stronger and more dynamic than the Eurozone economy—that's not a surprise. But conditions in the Eurozone have nevertheless improved. In the two years since Japan's equity market suddenly came to life, U.S. equities are up almost 50%, and Eurozone stocks are up a little over 30%. In dollar terms, Eurozone equities are up about 20%. That's not chickenfeed.

It's hard to get pessimistic about the future when the world's stock markets are becoming more and more optimistic. Of course, it's hard to see significant improvements anywhere right now, but in my experience it sometimes takes awhile before the average person realizes the extent to which economic conditions have actually improved. For now, the world's stock markets are seeing better times ahead, and investors seem to be getting the message.

Despite all the gloom out there, and despite all the disappointment, there is reason to be optimistic. If we've learned anything in the current recovery it's that 1) fiscal stimulus (e.g., the ARRA) doesn't work and 2) monetary stimulus (e.g., QE and zero interest rates) don't work either. Government policymakers cannot conjure up prosperity by spending more money or cutting interest rates. What's needed is for government to get out of the way and boost incentives for the private sector to jump-start the economy. That means lowering marginal tax rates, simplifying tax codes, eliminating subsidies, and reducing regulatory burdens.

This is not rocket science. The entire world has witnessed massive, almost laboratory-type experiments in fiscal and monetary stimulus fail to deliver the promised results. There's nothing left to try except what is most likely to work. Politicians need to hand the reins over to the private sector and market forces and step aside. The world's stock markets seem to be saying that this is a real possibility that may come to fruition within the foreseeable future.