Commentary by Dr. Ed Yardeni, from “Dr. Ed Yardeni’s Economics Network”, June 1, 2010 Among the biggest risks for investors is that Washington’s frenetic urge to pass thousands of pages of new legislation empowering the government to control more of the economy will cap the corporate profits gusher, which has been so bullish for the economy and for the stock market over the past year. The 27.7% increase in the S&P 500 over the past year from May 8, 2009 through April 30, 2010 has been attributable to a 36.7% rebound in the composite’s forward earnings over this period, while the forward P/E fell 6.8%. Despite all the turmoil in Europe, S&P 500 industry analysts only slightly trimmed their consensus profits forecasts for both 2010 and 2011 during the week of May 21 to $82.16 and $96.61, respectively, so forward earnings rose to a new cyclical high of $88.00. The latest profits data included in the National Income & Products Accounts (NIPA) released by the Bureau of Economic Analysis (linked below) are just as impressive, though the future may be less so: (1) Pre-tax corporate profits from current production rose for the fifth quarter in a row to $1,549.0bn (saar) through Q1-2010. That’s up $425.4bn, or 37.9%, over this span, and is only 6.4% below the record peak of $1,655.1bn during Q3-2006. Domestic financial and nonfinancial industries accounted for 70.4% and 28.6% of the increase in pre-tax profits since Q4-2008. The “rest of the world” accounted for only 1.0% of the increase. (2) This measure of corporate profits includes inventory valuation and capital consumption adjustments. So it is a reflection of cash flow from profits. After taxes, it rose 39.6% over the past five quarters. Depreciation expenses for tax reporting purposes dropped sharply during the first quarter. As a result, total corporate cash flow rose to a record $1,607.0bn during Q1. (3) The rebound in the NIPA measure of profits is likely to run into some headwinds. Financial firms have benefitted from lots of government support and guarantees. Most importantly, in my opinion, have been the FDIC’s guarantees for bank debt and the Fed’s commitment to peg the federal funds rate near zero. These measures dramatically boosted the profitability of financial companies by widening their intermediation spreads. The Fed’s zero interest rate policy also provided them with sizable capital gains on their securities. The suspension of mark-tomarket (MTM) accounting a little over a year ago was also a big profits booster. Now Washington has turned populist and seems intent on punishing the very same financial firms that were bailed out. Financial reform legislation includes several measures that could severely reduce the profitability and global competitive position of the US financial industry. Oh, and FASB is back with an insane proposal to bring back MTM and apply it to bank loans. According to NIPA, pre-tax corporate profits earned by financial firms plunged 72.8% from a record $447.5bn (saar) during Q2-2006 to just $121.9bn during Q4-2008. The financial crisis was downright ugly. But since then, there has been a remarkable and spectacular recovery as financial industry profits soared 245.8% to $421.5bn during Q1-2010. That’s just 5.8% below the record high. Honestly, it seems a bit exaggerated to me. In Figure 7 of our “Profits, Productivity, and Prosperity” chart book (linked below), we plot this series versus the forward earnings in billions of dollars of the S&P 500 Financials sector. This latter measure is up 110.6% over the past twelve months through May, and still 46.5% below its record high of $242.1bn during August 2007. Figure 8 in our chart book shows that the share of corporate profits attributable to the financial industry peaked at 34.2% of the NIPA pre-tax total during Q1-2003 and fell to 10.8% during Q4-2008, the lowest reading since Q41984. It rebounded to 27.2% during Q1-2010. On the other hand, the S&P 500 forward earnings data show that the industry dropped from a record 28.7% share during July 2003 to 11.3% during May 2009. Since then, it rebounded to 16.4% during May. (4) A bigger potential headwind for US corporate profits may be blowing out of Europe. Slower economic growth over there and a weaker euro could be major drags on profits reported by American companies. While companies report their revenues earned in various parts of the world, they rarely do the same for their profits. As a rough proxy, US merchandise exports to Europe including the UK accounted for 20.1% of total US exports during March, down from a peak of 26.8% during March 1991 based on data starting during January 1974. So Europe matters to US companies, but less so. The NIPA pre-tax profits total includes a component for the “rest of the world” (ROW). It is the difference between receipts (ROW-R) and payments (ROW-P). Debbie and I tend to focus on ROW-R as the best measure of profits from overseas. It has exceeded the profits of the financial industry for the past 15 quarters, and accounted for 32.1% of the total during Q1-2010 (Fig. 6). In Figure 12, we show that its growth rate on a y/y basis is highly correlated with the comparable growth rate in OECD industrial production and US merchandise exports. It’s also inversely correlated with the trade-weighted dollar.
The Euro-Mess and the weak euro are bound to depress earnings from abroad. However, it is a big world. As Debbie and I noted previously, US companies are exporting more to emerging economies and should continue to earn more of their profits over there. In other words, there are lots of challenges, but also lots of opportunities for US corporations in the global economy. * Corporate Profits: What’s the latest on profits? They are rebounding and so is cash flow. After-tax profits, based on tax returns, climbed for the fifth straight quarter during Q1, soaring 66.5% over the time period to a new record high. Profits from current production also rose for the fifth straight quarter, up 25.4% over the span, and within 2.5% of its Q3-2006 record high. Cash flow from current production increased for the sixth time in seven quarters to a new record high. Last quarter, pre-tax profits from current production accounted for 12.3% of National Income, above Q4-2008’s seven-year low of 9.0%, and below Q3-2006’s near record high of 13.7%. After-tax nonfinancial corporate profit margin is volatile around recent lows, moving up from 6.4% to 7.4% the past four quarters. It’s considerably below Q3-2006’s cyclical peak of 9.7%. It coincides with the capacity utilization rate, which is increasing slowly from June’s record low of 68.3%. * Profits from Abroad and of Domestic Nonfinancial & Financial Corporations: How important are profits receipts from overseas to overall profits? They accounted for 32.1% of the total during Q1, down from a record high 42.6% at the end of 2008. They climbed above domestic profits earned by financial corporations in the US during Q3-2006, though the gap is narrowing. Receipts from overseas rebounded 23.8% y/y from a record 28.9% drop just a year ago. It was the first positive reading since Q3-2008. Overall domestic profits rose 39.8% y/y last quarter, posting the first back-to-back positive readings in three years led by a surge in financial profits, though the pace slowed to 77.2% y/y last quarter from over 200% during Q4. The growth rate of foreign profits of US corporations is highly correlated with the growth of OECD industrial production and US exports, which are growing briskly. It is inversely correlated with the trade-weighted dollar, which has strengthened recently.
Commentary by Dr. Ed Yardeni, from “Dr. Ed Yardeni’s Economics Network”, June 1, 2010