"[T]he current earnings target for the S&P 500 for 2011 is higher than actual earnings in 2006, the last full year before the subprime mortgage meltdown. So it doesn't seem at all as if a possible slowdown in global economic growth is factored into the market at all."
-- CNNMoney.com, June 23, 2010
I beg to differ. Consider this chart:
These aren't estimates made by some rosy-eyed kook, mind you. These are actual, in-the-books business profits -- and they're already higher than the previous peak reached in 2006.
Now, these are economy-wide profits, not just S&P 500 profits, so this chart may not be perfectly representative of the stock market. But the trend is obvious: Corporate America is back, and it's more profitable than ever.
While you were sleeping ...
How, you'll ask, did we manage such a ferocious rebound? A few points to consider:
- Businesses have become phenomenally efficient, as shown by the surge in labor productivity. When productivity rises, companies are extracting more output from each unit of labor. In other words, they're producing the same amount while employing less people. Incredibly, real (inflation-adjusted) GDP is higher today than it was in 2006, even as unemployment more than doubled. This is awful for the jobless, but it's been a godsend for corporate profitability.
- The earnings crash in 2008 had less to do with falling demand as it did a one-time purge of leveraged financial balance sheets. The magnitude of losses at companies like Citigroup
(NYSE: C)and AIG (NYSE: AIG)didn't reflect the greater economy, yet they were enough to annihilate aggregate profits. Put another way, the crash, not the rebound, was the aberration. That's not saying aggregate profits didn't deserve to fall -- did they ever! Just not to the degree financial profits skewed the big picture in late 2008.
- Between the zero-percent interest rates, government-subsidized capital, and outrageous accounting leeway, banks have been handed the most generous earnings environment in the history of the universe. As Warren Buffett put it in early 2009: "Banking has never been better in one sense. I mean, the banks are getting their money very cheaply ... spreads have never been wider, all the new business they're doing is terrific." And it was. Goldman Sachs
(NYSE: GS)couldn't stop making record profits if it tried. And since financial industry makes up 21% of national GDP, their results have a big impact on the aggregates.
- Businesses have been restocking inventory like champions, which actually accounted for the majority of GDP growth late last year. This, however, is a temporary phenomenon. The profit rebound isn't as impressive when adjusted for inventory valuations, although it still shows current profits rebounding all the way to back to 2006 figures.
- Profits shown here nominal (not adjusted for inflation), which somewhat explains the record highs. While inflation has been mute lately, it's hasn't exactly been eliminated. The overall consumer price index is roughly 8% higher today than it was in 2006. The sharp rebound in the price of oil that took place in 2009 was a major profit booster for companies like ExxonMobil
- Stimulus and other giveaways have without a doubt juiced profits. Cash for Clunkers, for example, was a big (albeit temporary) win for auto manufactures like Ford
(NYSE: F)and GM. KB Homes (NYSE: KBH), among other homebuilders, was able to turn genuine losses into sizable profits thanks to tweaks of the tax code.
There are other reasons. But these six, in that order, explain most of why profits have rebounded to record highs.
Where to now?
The big questions are whether the current profit highs are sustainable, and if so, what they mean for market valuations.
I have my concerns about the economy, but betting on sustainable profits seems like a fair bet. Corporate leaders have proven that the bottom line won't be sacrificed by anything (including employees), and will do anything short of slave labor to keep profitability intact. That's what they're incentivized to do. True, there's an eventual limit to how much productivity companies can squeeze out. But it's never paid to bet against the flexibility of the U.S. economy. The speed of the profits rebound may have topped, but you have to be certifiably nutcase bearish to expect a substantial drop from here.
As for valuations, that's up for the market to decide. To quote James Grant:
To suppose that the value of a common stock is determined purely by a corporation's earnings ... is to forget that people have burned witches, gone to war on a whim, risen to the defense of Joseph Stalin, and believed Orson Welles when he told them over the radio that the Martians had landed.
There are cheap stocks out there, especially after the recent pullback. Unfortunately, the psychological trauma polluting investors' moods might keep those stocks cheap for a while. Patience is at a premium these days.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.