E not PE
There’s a bubble in U.S. stocks – but it’s in profitability, not valuation metrics. The S&P 500 Index trades at 14 times historical earnings, so the valuation multiple isn’t excessive. But a measure of domestic U.S. profit margins stands 50 percent above its long-term average. Global profitability has soared even higher. This is unlikely to last long.
Globalization is one factor driving up profit for companies in the United States. According to a March 2011 paper by the Bureau of Economic Analysis, foreign earnings represented 40 percent to 45 percent of total profit between 2008 and 2009, against around 20 percent in the 1980s.
However, even narrowing the scope to just domestic activities, profitability is still startlingly strong. In the first nine months of 2011, the aggregate post-tax profit of all corporations totaled 7.2 percent of gross domestic income, a measure similar to GDP. That’s well above the cyclical peaks of 6.4 percent in 1997 and 2006 and the postwar record of 7.1 percent. In the BEA’s records, the ratio of domestic profit to GDI was only higher in 1929, at 8.8 percent. The current level is half as high again as the long-term average of 4.8 percent.
A chunk of the surge in profit derives from interest rates. Corporate leverage has increased in recent years, according to the Federal Reserve, and the debt of U.S. nonfarm businesses currently amounts to 60 percent of the value of their equity. However, interest rates have declined. Ten-year Treasury bonds yielded more than 10 percent in the 1980s but under 3 percent in 2011. Based on recent corporate leverage, this decline in the cost of debt would increase the typical company’s return on equity by more than four percentage points. Conversely, corporate profitability in the high interest rate 1980s was well below the long-term average.
A deceleration in profit growth, at least, may already be priced in. Standard & Poor’s calculates that analysts now anticipate less than 1 percent earnings growth for the first quarter of this year compared with a year earlier, down from their rosier expectation of more than 12 percent growth less than a year ago. But if interest rates start rising, perhaps along with wage costs, say, a sharp decline in profit could follow. Suppose the profitability of companies in the United States declines to the 80-plus year average and valuation multiples remain constant, and the S&P 500 would be at 900 rather than its current level of around 1,360. That’s food for thought for stock market bulls.