Friday, August 26, 2011

Corporate Profits, Economic Growth, and Equity Valuation

Scott Grannis asks:

Corporate profits are fantastic—what's wrong with equity prices?
As I've discussed numerous times (an example is Equity Valuation Matters), over the long run, earnings matter for equities and those earnings are very closely tied to underlying economic activity. However, over the short-run, earnings (and equity prices) may dislocate from the underlying economy due to a number of factors. In the current market where earnings have dislocated in a positive direction, some reasons may include cost cutting, accounting that allows banks to smooth write downs, low taxes, cheap financing, and a lack of competition for corporations (i.e. the struggles we've seen within the small business sector).

This is another way of saying that all earnings are not created equal. If earnings could in fact consistently grow faster than the underlying economy, then earnings would eventually be larger than the economy itself (a mathematical impossibility). A warning sign is that in the most recent data, as shown in Scott's chart, corporate earnings as a percent of GDP are above 10%, 4% above its 50+ year average.

While this 10% level is unprecedented over the past 50+ years, dispersion between earnings and/or equity performance and nominal economic growth is not. However, in the long-run (sometimes a very long-run), the relationship tends to be very tight. The chart below shows this connection in a chart normalizing data going back to 1951 (the BEA has data going back three more years to 1948, but the relationship is the same).

As for equities being cheap, I actually happen to believe there is in fact a lot of value out there, but I personally wouldn't call the broader market cheap with all the tough issues that need to be addressed. In addition (ignoring whether earnings are / are not sustainable), it matters when you start looking. As Scott outlined, over the last 10 or 20 years, earnings have grown faster than equity valuations. However, over the last 60 years (i.e. the chart above), equities are actually outperforming (i.e. P/E's have expanded).


  1. Very nice article, and im one of those that believes equity is a lot more valuable than earnings.

  2. Interesting chart - thanks for sharing. Does the calculation for the S&P 500 include dividends?

  3. It does not include dividends. S&P returns typically equal dividend rate + nominal GDP growth over the long run.

  4. Your chart starts in 1951. At that time the cyclically-adjusted P/E ratio (based on 10-year trailing average earnings a la Shiller) was about 12. Today it is about 22.

    So unless you think the P/E is going to keep inflating up to 40 or so in the next six decades (highly implausible), the S&P index growth will probably have to fall below GDP growth.

    (On the other hand...stock repurchases.)