Today's release of fourth quarter GDP revisions showed little change, but it did provide us with the first look at corporate profits for the quarter. After-tax corporate profits rose 8.5% last year to $1.58 trillion on a seasonally adjusted annual basis. As the charts above show, this was a record both in nominal terms and relative to GDP; in fact, corporate profits have been breaking both these records since the fourth quarter of 2009.
Ordinarily, you would think that 9 consecutive quarters of record-setting corporate profits would be cause for great celebration on Wall Street, with jubilant investors sending PE ratios to the moon, but you would be dead wrong. Instead, the PE ratio of the S&P 500 today stands at 14.4, well below its 50-year average of 16.6, and down sharply from its Q4/09 average of 21. What does this mean? It's simple: investors don't believe corporate profits can continue to rise, having already wildly exceeded previous highs relative to GDP. Indeed, I would argue that the stock market is priced to the expectation that corporate profits are likely to decline significantly, both in nominal terms and relative to GDP. Call it a mean-reversion expectation: profits, according to the market's logic, should sooner or later return to their long-term average of just over 6% of GDP, and perhaps fall even further—there's no way they can remain this high.
I think this is a pretty pessimistic outlook, but no matter what adjective you use to describe the market's expectations, it would not be anything like optimistic.
This chart of U.S. corporate profits (the same profits used in the other charts above) relative to global GDP puts the issue in a whole new light. Suddenly, profits are not usually high at all. Why the huge difference? U.S. corporations have been busy globalizing in recent decades, and the global economy has been growing much faster than the U.S. economy. U.S. corporations now address a global market that has grown by leaps and bounds, and profits as a share of global GDP are about average. It no longer makes sense to look at corporate profits as a share of U.S. GDP. Anyone who today can sell his products and services to the world has the ability to make profits that were inconceivable just a few decades ago. For starters, think Apple, Hollywood, and Qualcomm: Apple is now a major player in the gigantic Chinese mobile phone market; Hollywood films are watched by billions of eyeballs; and Qualcomm chips are in the vast majority of smartphones, the fastest growing segment of the global mobile phone market. In short, the rationale for expecting a significant deterioration in corporate profits that seems to have infected the equity market is not compelling at all.
And that means that you don't have to be a wild-eyed optimist to like today's equity valuations. Even if you don't think that U.S. growth is going to pick up in any meaningful fashion for a long time, profits could continue to impress.