Stock Prices to Eventually Ratio

By Jeffrey Snider

The Bureau of Economic Analysis (BEA) revised upward fourth quarter 2017 Real GDP. The second estimate had been revised lower to 2.50458% (continuously compounded annual rate of change) from the advanced estimate. The third and final calculation raises the quarterly increase to 2.84707%. None of the changes are substantial.

Accompanying these revisions are the BEA’s first assessments for Corporate Profits and Net Cash Flow during the quarter. The latter being one of the more descriptive and illuminating of data points over the past decade, Corporate Net Cash Flow plummeted 36% in Q4. From $2.2 trillion (SAAR) in Q3, the current estimate of $1.4 trillion indicated a radical departure.

Obviously, such a massive reduction isn’t likely to be anything other than a statistical issue or discontinuity. In this case, the tax reform law that was enacted at the end of last year is to blame. From the BEA:

The new tax law imposes a one-time deemed repatriation tax on accumulated foreign earnings. This tax is recorded as a capital transfer from business to federal government of $250 billion at a quarterly rate ($1 trillion at an annual rate) in the fourth quarter. This transaction does not impact GDI, national income, national savings, or corporate profits, but does decrease corporate cash flow…

Other parts of the tax law have had varying effects on other profit accounts. The Bonus Depreciation portion causes distortions in those with the lone exception of Corporate Profits w/IVA and CCadj (often called “profits from current production”).

The new tax law provides for full expensing of qualified investments placed in service after September 27, 2017 and before January 1, 2023 and increases the expensing limitation from $500,000 to $1 million. BEA’s estimate of profits from current production is not affected by the change; it reflects economic depreciation based on an estimate of the reduction in the value of fixed capital used in the production process.

It is that last reason why we pay more attention to this particular profit set. So, while there is somewhat good news in that overall corporate profits and cash flow didn’t actually plummet in Q4, according to profits from current production they didn’t increase, either. That’s a problem, the big problem in fact.

There has been only a small rebound from the “rising dollar” downturn that in these terms amounted to a “profit recession.” It is almost surely the lack of acceleration in corporate profits, especially those derived from organic business activities, that is responsible for years of persistent slowing in the labor market from the first appearance of negative monetary effects in 2015.

Importantly, even though Q4 2017 is seven quarters after that low point, profits from current production remain slightly lower than the prior peak registered in Q4 2017. This is not what stock prices, in particular, have been anticipating. It also undercuts the inflation hysteria narrative provided especially by the unemployment rate; adding further basis to alternate views on the labor market that run contrary to wage acceleration and even economic recovery overall.

Though we have to discount other profit estimates for Q4, this unaffected series tells us that the sluggish nature of the upturn prevailed throughout all of last year. There was no shift in trend consistent with the hyperbolic rhetoric of a boom. Rather, the struggles in profits (and likely cash flow apart from the distortions) further emphasizes the lackluster nature of it, and therefore this continued “ceiling” on growth in addition to its uneven fashion.

While the BEA’s estimates for Profits After Tax declined 12% in Q4, the Federal Reserve’s Z1 accounts figured another 5% increase (in just the one quarter) for corporate equities held as assets. Even if we assume that these profits were instead flat Q/Q as they were for profits for current production, that would still mean Profits After Tax are up just 29% from the low in Q4 2015. At the same time, two full years, corporate equities (assets) have increased by a nearly identical amount (28.8%).

If valuations haven’t therefore been any better on the upswing, a wider historical comparison shows just how stretched they have become. Profits haven’t grown since Q4 2014 (again, assuming profits in Q4 2017 were the same as Q3 2017 instead of significantly lower). Over that same period, three years, corporate equities (assets) have surged by an astounding 25% – almost all of it since early 2016.

Going back to 2012, profits are up just 8% total (ignoring Q4 2017’s decline); not per year, total. Equity prices have gained 82%.

Many attribute that difference to central bank largesse, the “money printing” operations of so many global QE’s. The lack of profit growth, as economic growth, easily belies any such notion.

Instead, QE affected expectations and investor psychology (so much for efficient markets and its predicate theory on rational expectations). Working through savings, not money, investors piled into stocks on the basis that those monetary programs would work in the real economy eventually. We are, obviously, still waiting.

Only the gap between expectations and reality, valuations, has become increasingly absurd and in two dimensions, not one. The first is the proportions, which are only like the late 1920’s and the late 1990’s (dot-coms) in historical experience.

The second dimension is time; meaning, that going as far back as 2012 (and the global slowdown rather than acceleration) it’s increasingly definitive on the matter (just ask the Chinese). Six years is more than enough time to judge the economic case, as well as that of the monetary programs intended to aid full recovery beyond the mere continuation of uneven positive numbers with a deceptively low ceiling.

What the price side of the P/E ratio has been expecting is pegged by this large sample of time as a very low probability event. It may not have looked that way in early 2013 as stocks initially took off (though it might have been different if people realized what QE actually was, and had already been shown to be with QE’s 1 and 2), but at this point to expect a massive upward inflection in the economic baseline (the dramatic S-curve shift) would require substantial changes in everything about the economy, and thus there would be one of similar proportions in a broad range of statistics.

About the only trend that may have qualified last year was that temporary three-month window following Harvey and Irma. Even then, it was more delusion than rational analysis. Now that it is being revealed that way with further 2018 data, stocks overall on valuations (in two dimensions) look increasingly risky. If the upturn following the “rising dollar” profit recession and the near-recession in the global economy didn’t produce the cyclical forces required to engineer the recovery case at last, what’s left that might?

Jerome Powell’s rate hike dot plots is hardly convincing in that way, particularly when the bond market (long end) as well as eurodollar futures continue to be aligned against it. Valuations are mean reverting given enough time. A recovery trend and economic symmetry might propose that it is earnings that revert given even robust prices. Those, however, aren’t anything like we see anywhere in the world and haven’t for a decade and more.

As earnings continue to refuse validation of prices, the “E” in P/E isn’t meant to stand for eventually.

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