Wednesday, March 30, 2011

Nonfinancial Corporate Earnings: Could They Keep Falling Until the Economy Passes Through Another Recession?

While I ponder aloud whether this is a healthy stock market for investors (as opposed to momentum traders), this will be my second post on the topic, following the last post that graphed long term trends in earnings.

I tend to avoid analyses that take the form of "whenever A happened in the last B years, then C occurred at least D percent of the time." Much of the time this indicates data mining to validate a favored conclusion, whether bullish or bearish. While this post risks getting closer to that territory than I'd like, I'm going to avoid actually calculating percentages and such and keep it vague and qualitative! I have no clear conclusions, I simply found the data interesting.

Here is a graph of nonfinancial corporate business profits after tax (NFCPATAX) and financial corporate business profits after tax (CP minus NFCPATAX) from the national accounts data, generated via FRED2.

  • Nonfinancial profits (the blue line) fell a nontrivial amount in Q4 2010. Have they peaked for this expansion? Or was there a special one-time event (such as an expiration of tax-friendly legislation) that explains it?
  • Look at the historical pattern of past occurrences of nonfinancial profits first starting to fall. If the drop was nontrivial in size, nominal nonfinancial profits continued to fall and only reversed course once a recession had occurred and was reaching its end! This process seemingly can take several years to occur (e.g., especially in the late 1990s).
  • The most obvious exception to the pattern is in the mid 1980s — a large drop in earnings was later followed by resumed earnings growth, with no recession.
  • Financial profits (the red line) in the period leading up to and through recessions have acted quite differently than nonfinancial profits. In the 1991 and 2001 recessions in particular, financial profits kept growing, largely unfazed by recession! This perhaps had a lot due to with the rapid growth in household debt as well as the steeper yield curve due to the Fed lowering rates.
Here is the same data ending in 1992, so that the vertical scale for the earlier years is more visible:

The pattern of nonfinancial profits peaking in nominal terms months or years before recession occurs seems similar but less pronounced than in the later periods. Note that I am intentionally graphing nominal profits in all cases, rather than a ratio such as to GDP. This is because stock prices are likely more sensitive to nominal profits than profits ratios.

A natural question for an investor would be, what are the implications for stock prices?

Here is a graph of nonfinancial corporate profits and the value of the S&P 500 index:

Does the point at which nonfinancial earnings peak represent an "overvalued" stock market price, given that recession often follows within a few years? It appears that in many cases, the stock market continued to rise after earnings peaked, and the eventual stock market low during recession wasn't always lower than the stock price had been at the time of that prior peak in earnings. Thus, waiting to buy stocks wouldn't necessarily have provided a lower entry point in the future. There are of course exceptions, for example the most recent recession taking stock prices well below their price at the time of the prior peak in nonfinancial earnings.

I can suggest no insights from this data regarding the eventual impact on stock prices even if the current contraction in nonfinancial earnings continues. The future direction of financial sector earnings may turn out to be a key determinant of the outcome. Plus, as is well known, valuation multiples expand and contract independently from changes in earnings.

Here is the same data repeated but only up to 1992, so the vertical scale for the earlier years is more clear:

Thursday, March 24, 2011

Stock Market Earnings Trends: What Happens This Decade?

What is the outlook for US stock market returns over the coming decade? There is no shortage of commentary on this topic, and I don't have any unique answers, but I thought I would share two graphs.

A lot of market commentary suggests the stock market is overvalued on the basis of measures such as stock market capitalization to GDP, Shiller's CAPE (10 Year Average Inflation-Adjusted PE ratio), Tobin's Q, etc. But for any elevated ratio, a reversion to the mean can occur via a combination of falling numerator and/or rising denominator. For example, GDP could grow rapidly while stock market valuation grows slowly, allowing the ratio of market cap to GDP to mean revert without a fall in earnings and stock prices. But how likely is the numerator to fall? That is what would most concern a medium to long term investor.

One prediction in particular that caught my attention was Robert Shiller's suggestion that the S&P 500 will be around 1430 in the year 2020. With the S&P 500 currently around 1300, that represents roughly a 10% total increase (not annual!) over a decade. Robert Shiller is known for recognizing both the dot-com bubble and housing bubble long before most people, so he is worth listening to.

Here is a chart of trailing 12 month reported earnings created from Shiller's spreadsheet, from 1871 through Q3 2010:

The green exponential trend line shows the long term earnings trend. Current earnings have rebounded quickly to well above the trend line. If earnings oscillate around this trend line as they have done historically, they should be centered around roughly $60 in 2020! At a 15 valuation multiple, that only represents an S&P 500 index value of 900 (a 31% decline!) However, this trend is for real (inflation adjusted) earnings, so the nominal level of earnings and corresponding S&P 500 valuation would be somewhat higher assuming continued positive inflation.

But what about the most optimistic case from the perspective of the stock market? What if we are in a sustainable new era in which the recent extraordinary corporate margins, earnings to GDP, etc, can be maintained indefinitely? The next graph shows the same trend line since 1980 but for nominal reported earnings. The red portion of the line is the estimated forward earnings from Standard & Poors S&P500 spreadsheet as of today, which is important because expected earnings represent what the market valuation is currently priced for, i.e., earnings of $90-$95.

This trend line shows the nominal earnings trend reaching the $90-$95 level around 2020. So current earnings and forward estimates are ten years ahead of "schedule"! This second graph seems to align with Shiller's suggestion of an S&P index of 1430 in 2020 (with a 15 valuation multiple, earnings would be $95).

The key question for a stock market investor is what happens to that earnings line over the next decade: does it remain above trend line (not impossible, if you look at the late 1990s period), does it crater again as in 2008-2009, or does something else occur?

This graph shows the extent to which nominal earnings can fall: a 35% fall from 1989-1991, a 54% fall from 2000-2001, and a 92% fall from 2007-2009 . So history shows that a falling numerator is not uncommon, i.e., reversion to mean not exclusively driven by a rising denominator. If falling earnings is a reasonably probable scenario, the next question is, when? With labor cost pressures low and held down by high unemployment, and rising commodities costs representing a possibly more manageable percentage of most cost structures, is a contraction in GDP the only thing that could meaningfully reduce earnings?

Comments are welcome.