An Open Letter to the FOMC: Recognizing the Valuation Bubble In Equities John P. Hussman, Ph.D.
The chart below is from one of the best tools that the Fed offers the public, the Federal Reserve Economic Database (FRED). The chart shows the ratio of corporate profits to GDP, which is presently at a record. The fact that profits as a share of GDP are more than 70% above their historical norm should immediately raise a question as to whether current year earnings or next year’s projected “forward earnings” should be used as a sufficient statistic for long-term cash flows and equity market valuation without any further reflection. Then again, more work is required to demonstrate that such an approach would be misleading. We’re just getting warmed up.
A simple way to see the implications of the present elevation of the profit share is to relate the level of profit margins to subsequent growth in profits over a reasonably “cyclical” horizon of several years. Remember, when one values equities, one is valuing a long-term stream, not just next year’s earnings. Investors taking current-year or forward-year profits as a sufficient statistic should be aware that high margins are reliably associated with weak profit growth over subsequent years.
The next relevant question is to ask why profit margins are presently so high. One might argue that the profitability of companies has achieved a permanently high plateau. Despite historical mean-reversion in profit margins (which tend to collapse over the full course of the business cycle), maybe this time is different. As it happens, we can relate the surfeit of corporate profits in recent years rather precisely to the extraordinary combined deficits of the household and government sectors during the same period.
|Box: The deficits of one sector emerge as the surplus of another|
To see what’s going on, we can exploit the savings-investment identity
Investment = Savings
Investment = Household Savings + Government Savings + Corporate Savings + Foreign Savings (the inverse of the current account)
Corporate Profits = (Investment – Foreign Savings) – Household Savings – Government Savings + Dividends
This basic decomposition, at least to an approximation allowed by national income accounting and modest statistical discrepancies, is shown below (h/t Jesse Livermore, Michal Kalecki).
We can go further. The reason (Investment – Foreign Savings) are in parentheses above is because particularly in U.S. data, they have an inverse relationship, as “improvements” in the current account are generally associated with a deterioration in gross domestic investment. So the term in parentheses adds very little variability over the course of the business cycle. Likewise, dividends are fairly smooth, and add very little variability over the course of the business cycle.
As a result, the above identity reduces – from the standpoint of overall variability – to a statement thatcorporate profits as a share of GDP are nearly the mirror image of deficits in the household and government sectors. A simple way to think about this is that dissaving in both sectors helps to support corporate revenues and limit the need for competition, even when wages and salaries are depressed. It follows that most of the variability in corporate profits over time is driven by mirror image variations in the household and government sectors. As it happens, this relationship turns out to be strongest with a lag of roughly 4-6 quarters. Given the general improvement in combined government and household savings that began just over a year ago, it follows that current-year or even higher year-ahead earnings estimates may not be particularly useful “sufficient statistics” for the purpose of valuing equities.
A predictable response among investors is to immediately seek alternate explanations that might allow profit margins to remain permanently elevated. First among these is the argument that somehow the production of U.S. companies abroad is not being taken into account. But the difference between Gross National Product (which does exactly that) and Gross Domestic Product – even if it represented pure profit – is only about 1%. The adjustment might make a difference in Ireland, where the gap between GNP and GDP is far larger, but the effect is purely second-order in the United States. Moreover, any additional dynamic that prompts the claim “this time is different” had better be one that emerged in the past few years, because as the charts above demonstrate, the mirror-image relationship between variations in corporate profits and variations in combined government and household savings has hardly missed a beat in the past century.