More on Corporate Profits

Back in September of last year, I showed this chart outlining that corporate profits as a percent of GDP were approaching a three-standard deviation event. Since that time, the relationships has gotten even more extended hitting an all-time high.

Which brings me to this morning's tweet from PIMCO's Bill Gross:

Simple formula: US profit growth rate = (real GDP x 5) – 10. No “ka-ching” at 2% or less GDP growth.

I appreciate the insight that profits can be thought of as being leveraged to economic growth (hence the wide fluctuations), but struggling to see why nominal profit growth would have a relationship with a real (after inflation) economic growth or why those specific numbers (why 2% real and not 2.5% real?) were used.

Anyhow... I was interested enough to see what this equation looked like using actual data, so I put together the below chart going back 60 years against corporate profits, as well as against my old simple standby of using nominal economic growth (my preferred long-term measure for corporate profits as simple math tells you that corporate profits can't grow faster than the economy over the long term or else they'd be bigger than the economy itself - hence profit growth tends to mean revert relative to nominal growth).

The chart...

What do we see?

Well corporate profits are basically right on trend (a surprise to me), but nominal growth is well below trend and the PIMCO formula (the formula based on 2% real growth) is WAY below trend, indicating corporate profits are significantly above trend (by that record 30% level relative to nominal growth and an off the charts 200% relative to the PIMCO formula).

Seems like the old nominal GDP standby has historically been more reliable, but I will be thinking more about the insight that corporate profits are leveraged to (and in need of) specific levels of economic growth. If anything, this may indicate earnings are potentially more stretched than I previously thought.

For those interested, there was a great piece by GMO on the topic of extended profits a few months back.

Source: BEA

Corporate Profits vs. Personal Income

Stagnant wages and outsourced production (reduced expenses for corporations - higher unemployment / underemployment for individuals), combined with cheap financing (lower interest payments for corporations - lower income on savings for individuals) have fed record corporate profits, while personal income slowly rebounds (and remains below pre-crisis levels).

Another way to view the same data is to compare real corporate profits (still the red line) with the difference between real GDP growth and real personal income. What we see is that when real GDP grows faster than real personal income, more of national income makes its way into corporate bottom lines.

What this misses is that for corporate income to continue to grow either:

• National income needs to grow
• Corporations need to grab an even larger slice of national income from individuals

Both of which will be much tougher on a going forward basis (the former a good thing, the latter not so much).

Source: BEA

Extended Corporate Profits

Source: Federal Reserve (Flow of Funds - Section F.7)

Corporate Profits Continue to Bounce Back

Credit Writedowns details:

Corporate profits were revised higher to 8.0% from 5.5%, which is the same as in Q4. Corporate income taxes also rose and the increased government revenue is one the reasons why the size of the monthly Treasury auctions have been reduced slightly. On an after tax basis, corporate profits rose by 5% rather than the early estimate of 2.1%.

Source: BEA

2008 Corporate Profits vs. Market Cap (Top 10)

Source: CNN Money

Corporate Profits Dropped Most Since 1953

WSJ reports:

U.S. corporate profits fell by $250 billion in the closing months of 2008, a staggering decline that many businesses are still struggling to offset.

Profits at corporations in the fourth quarter fell 16.5% from the previous quarter, the Commerce Department said Thursday. In the financial sector, profits fell by $178 billion -- and that figure doesn't reflect the industry's massive write-downs as the value of assets soured. The drop in pretax corporate profits was the steepest in 55 years. Compared with the same quarter in the previous year, the decline was more than 20%.

"It's horrendous," said Joshua Shapiro, chief U.S. economist at forecasting firm MFR Inc. in New York. "It destroys the ability of corporations to pay salaries, invest in equipment and do everything else that helps the economy grow."

Source: BEA

Corporate Profits Struggling

Ready for some ugly numbers? Well, according to the WSJ:

Corporate profits after taxes were revised a bit lower. After-tax earnings fell 3.2% to $1.300 trillion in July through September from the second quarter, the report showed. Profits previously were estimated falling 3.0%. Second-quarter earnings decreased 0.4%. Year over year, profits fell 10.1% since the third quarter of 2007.

Digging into the data, one can easily see the struggles corporations (and the public sector reliant on taxing corporate profits) are going through. The following sums it up:

• Undistributed profits down 30+%, corporate profits and profits down ~10%
• Taxes on income down (less profit to tax)
• Cash flow down (less profits + expensive financing to replenish cash)
• Consumption of fixed capital up (use it or lose it, fixed capital doesn't disappear)

Is there really any wonder why equities are down?

Source: BEA