Carpe Diem

If profits are the mother’s milk of stocks, we’ve got a stock market rally that could be sustainable for a long time

spprofrealDavid Stockman writes in today’s NY Times:

The Dow Jones and Standard & Poor’s 500 indexes reached record highs on Thursday, having completely erased the losses since the stock market’s last peak, in 2007. But instead of cheering, we should be very afraid.

Over the last 13 years, the stock market has twice crashed and touched off a recession: American households lost $5 trillion in the 2000 dot-com bust and more than $7 trillion in the 2007 housing crash. Sooner or later — within a few years, I predict — this latest Wall Street bubble, inflated by an egregious flood of phony money from the Federal Reserve rather than real economic gains, will explode, too.

Since the S&P 500 first reached its current level, in March 2000, the mad money printers at the Federal Reserve have expanded their balance sheet sixfold (to $3.2 trillion from $500 billion). Yet during that stretch, economic output has grown by an average of 1.7 percent a year (the slowest since the Civil War); real business investment has crawled forward at only 0.8 percent per year; and the payroll job count has crept up at a negligible 0.1 percent annually. Real median family income growth has dropped 8 percent, and the number of full-time middle class jobs, 6 percent. The real net worth of the “bottom” 90 percent has dropped by one-fourth. The number of food stamp and disability aid recipients has more than doubled, to 59 million, about one in five Americans.

So the Main Street economy is failing while Washington is piling a soaring debt burden on our descendants, unable to rein in either the warfare state or the welfare state or raise the taxes needed to pay the nation’s bills. By default, the Fed has resorted to a radical, uncharted spree of money printing. But the flood of liquidity, instead of spurring banks to lend and corporations to spend, has stayed trapped in the canyons of Wall Street, where it is inflating yet another unsustainable bubble.

MP: A few comments:

1. Banks are lending, at all-time record levels, see top chart above. The volume of commercial and industrial loans at America’s top 100 banks (by assets, data here) has been steadily rising for the last three years, and reached a new all-time record high of $1.2 trillion in the last quarter of 2012.

2. The middle chart above shows the historical relationship between the S&P 500 Index and after-tax corporate profits on a quarterly basis back to 1990. Between about 1990 and 1995 there was a pretty close one-to-one relationship between the S&P 500 Index and corporate profits – for every increase of $1 billion in after-tax corporate profits the S&P 500 Index increased by about one point. But starting sometime around 1996, after-tax corporate profits flattened out for the next five years (and decreased slightly in real terms, see bottom chart), while the S&P 500 approximately doubled, reflecting the dot-com bubble that was not supported by an equivalent increase in corporate profits, and was therefore unsustainable.

Then between about 2002 and 2006, the one-to-one relationship between increases in corporate profits and stock market values was re-established. But then corporate profits stated declining in 2007, but stock prices continued to rise to unsustainable levels and fell in 2008 as the recession and financial crisis brought about a major 40% stock market correction. Starting about 2009, a one-to-one relationship between stock prices and after-tax corporate profits has once again re-emerged, and the all-time highs for the S&P 500 Index in recent months are being driven by record-high corporate profits.

The last two market crashes that David Stockman refers to came about because stock prices “got ahead” of corporate profits, and rose to levels that weren’t sustainable because they weren’t consistent with the underlying corporate profits. In the current bull market rally, at least so far, corporate profits are consistent with stock market levels; and if that one-to-one trend between profits and stock prices continues, the current bull market is sustainable as long as profits continue to rise. Larry Kudlow reminds us frequently that “profits are the mother’s milk of stocks, and for that matter business and the entire economy.”  Therefore, as long as corporate profits continue to increase, we’ve got a bull market stock rally that could continue for a long time.

Updated: The new chart on the bottom is the S&P500 Index and corporate profits, with both series adjusted for inflation. My main points remain the same and unaffected by adjusting for inflation: a) the dot-com boom in real stock prices between 1996 and 2000 was not accompanied by an equivalent increase in real corporate profits, and was therefore unsustainable, b) real corporate profits in 2007 were declining while real stock prices increased to an unsustainable level, and c) the one-to-one relationship between real stock prices and real corporate profits has been re-established since 2009.

44 thoughts on “If profits are the mother’s milk of stocks, we’ve got a stock market rally that could be sustainable for a long time

  1. The Nasdaq bubble of the late ’90s was from revenue growth rather than profit growth. U.S. tech firms were creating and capturing market share, on a global scale, and the technology spilled-over into non-tech firms. In the 2000s, costs were cut to create huge profits.

    • The current bubble was created mostly by cheap labor and capital.

      Many workers are underpaid or overworked (while a high proportion of the labor force is idle and collecting government benefits) and interest rates (or cost of capital) are low.

      • Your use of the terms “mostly created by cheap labor and capital”, and “many workers are underpaid and overworked” makes your whole point an exercise in fuzzy thinking.
        You would have been on safer groung merely affirming that free markets will inevitably have their way and that bubbles eventually burst.
        It is not workers who are being exploited, it’s the unemployed and under informed who are being taken for a ride on the bubble of unsustainable government promises, and it’s the taxpayers who actually create more wealth than they consume who are being milked of the fruits of their labor to keep our increasingly mismanaged sovereign states nominally in the black.
        It will be the unsustainability of socialist state entitlements (including the good old US of A) in the face of a demographic tsunami that has the potential of wreaking far more havoc in the economy than will the federal reserve balance sheet. Corporate profitability is the Hadrian’s wall holding back the mindless passions of the masses that are easy to be lead into believing in the myth of the free lunch.

        • So, an umpire after seeing roughly an equal number of strikes and balls from a pitcher will assume that’s how it’ll inevitably be, or calling a ball, maybe a strike, isn’t “fuzzy thinking.”

          It’s a bubble only if it bursts, and economic boom/bust cycles are unnecessary. Going back to 19th century economics would be like going back to 19th century medicine. Of course, economics can be improved.

  2. I think, an important question is should a CEO pay himself $20 million, while paying some workers $20,000 (or a thousand times more), just because he can?

    However, it seems, workers don’t realize the economic policies of CEOs have generally resulted in lower prices and lower interest rates for every American. So, how much is that worth?

    • The economic policies of our politicians have generally resulted in higher prices and destroyed capital, particularly in health care, housing, education, energy, and small business, while they find ways to become rich.

      Government has been very effective in blaming Wall Street and Corporate America, while achieving undesirable effects, because the American people want more government.

    • Those CEO’s can do as they please. If they decide to take that huge cut of the revenue then they are taking that risk. No problem. The problem is that they are can kick and scream until they are bailed out in the name of those poor employees (thanks to your feelings and assumtions that the job of the owners and CEO’s are in business for that purpose, to employ). So I conclude that in a society where failure is under assault and thrown on the back burner, then CEO’s are going to play chicken…. and usually win. All they gotta do is make sure that the numbers they play with are large enough that what’s not fined is still ample.

      Welcome to the game.

      • gsatt-

        actually, no they can’t.

        owners can take an extra profits they like, but mostly, a ceo is an employee who is hired by a board of directors the compensation committee of which sets pay.

        the BoD work for the shareholders and are voted in by them. thus, the CEO cannot do as he/she pleases but rather is elected and paid by a sort of republic that is ultimately subject to the shareholders.

        thus, the ceo can really only do as he pleases if he owns all the stock (or at least 51%) this notion that CEO’s somehow set their own pay is just more peak foolishness.

        they do not “pay themselves” they negotiate with the BoD and have to convince others of what they are worth.

        • Yeah I sort of realized that after I hit submit. Although not everyone has a board of directors. Happens on all levels like the new restaurant owner that tries to live larger than he should before his business matures and he goes bankrupt and forecloses leaving his employees stranded. Is he a greedy jerk or a rookie?

          I’m aware that I cant generalize everything without being called on a technicality. cheers.

          • gsatt-

            actually, pretty much any ceo has a board of directors, at least technically.

            to be a corporation, you need a board. just what that means varies state to state, but the requirements does not.

            you are thinking of guys who are actually just owners or perhaps general or managing partners. some may call themselves ceo, but technically, to be a CEO, you have to be leading a corporation.

            i have no idea how to answer the greedy jerk vs rookie question. that seems like a case by case thing. there is no doubt that lots of businesses fail due to poor expense control. but if you put up all your own money for a restaurant and then go live large and blow it, well, wasn’t it your money? if you fail, you fail and lose your money. you wind up in a hole, the folks that worked for you got paid.

            i’m not sure these distinctions you are trying to draw are nearly as clear cut as you seem to want to make them out to be.

  3. average folks are still leery of the stock market… still have their money in “safe” but dismal earning investments.

    and who can blame them as many are looking at their 401Ks and realizing they have effectively lost 20%/5 years worth of earnings.

    • Two questions, Larry:

      1. What do you mean by the term “average folks”?

      2. Where did you get the data to support your assertion that those “average folks” have their money in safe but dismal earning investments?

      Have you actually seen any statistics at all about what 401K funds are invested in?

      • Larry sez:

        1. “people like me who need help getting dressed in the morning.”

        2. Data? I don’t need no stinkin’ data!

        3. No.

  4. actually, if you look at it historically, earnings yield and trend in earnings yield is not a particularly good predictor of forward equity prices.

    it can drop through a rally as in the 90′s, or rise as in the 2003-7 period and really bounces all over the place.

    you’d think it would be a better indicator, but it just isn’t.

    the thing driving this market is the fed. they are pouring surreal amounts of liquidity into the asset markets. that’s why this tape can shrug off bad news so easily: it means the fed keeps printing – watch what happens anytime someone at the fed mutters about ending qe and then watch the tape.

    this tape remids me a lot of the late 90′s. we all know the game is rigged, but it’s so profitable to stay in and try to get a little closer to the music stopping that you play anyway.

    • How important is the continuation of ZIRP(zero interest rate policy) of the Fed to the U.S. equities market?

      Since 2008, the stock market has experienced 30% of its gains on the day that the Fed Open Market Committee ends, and announces more ZIRP.

      So, if you are holding U.S. equities and the FOMC ends another session, it is probably(not guaranteed) “Happy Fed Day”.

      • cit b-

        very important. zirp keeps the discount rate low and makes bond look really unattractive as investments. this funnels money into equities.

        the current yield on the us 5 year is 0.75% which is pretty much a guarantee that you will lose money in real terms.

        not very attractive.

        of course, if you can buy them at 20:1 leverage and still call it tier one capital, well, then maybe it is, but most savers do not get to use the sorts of shenanigans banks do.

        and if you really want some sleepless nights, take a look at what happens to the NAV of a 20:1 geared portfolio if rates go from 0.75% to even 3 or 4% (which would be very low historically) and then ask yourself just how we get out of this corner into which we are painted without another bank crisis that makes the last one look like a day at the beach.

        my bet: bernanke holds steady through next year when he retires and hands this mess off to the next guy (or maybe gal if it’s yellen) just like greenspan did to him. handing over a bomb with a half inch of fuse is really not the sort of tradition one would like to see around fed succession, but given that politicians seem to use a discount rate of infinity, it seems like what we will get.

        • “…take a look at what happens to the NAV of a 20:1 geared portfolio…

          morgan, what is a geared portfolio?

          “my bet: bernanke holds steady through next year…

          I guess that Ben begins to slowly tighten Q1, 2014, because he thinks it to be the right policy at the time.

          • cb-

            sorry, gearing is the same as leverage and tends to get used interchangeably. thus, 20:1 leverage is the same as 20 gearing.

            ben’s term ends jan 31 2014. i have real doubts he will start tightening right before he goes.

            i suspect he will call this “leaving maximum flexibility for the new fed chair” or some such, but it i fear it will likely amount to handing over the bus from the movie “speed”.

    • morganovich: “earnings yield and trend in earnings yield is not a particularly good predictor of forward equity prices.”

      ONLY if you look at short term statistics, as you are doing. If you look at longer term trends – such as the 60 years through which a person should have savings invested – equity prices will follow the trend on corporate profits.

      • john-

        no, they do not. i think you may be misunderstanding what i said.

        earnings yield is the earnings of the S+P divided by it’s price and expressed as a %.

        as you can see from this data, if we go back to 1960, there is no trend in earnings yield.

        it’s also not a fully independent variable as earnings yield (and earnings themselves) are increased as dividends drop. there has been a pronounced drop in dividend yield in recent decades due to preferential tax treatment for long term gains.

        so, what we really want to look at is earnings + dividends and then look at a trend and compare it to the overall market.

        but, given that both are subject to inflation, of course both will rise over time which muddies this further. you could make the same claims about the price of iron and the price of beer.

        but again, here we are talking about earnings, not earnings yield.

        there is likely to be some increase in real equity prices due to increases in real earnings over time, but that was not what i was talking about.

        do you see the distinction?

        • also:

          be careful with charts like the one mark provided. i can make a chart with pretty much any 2 curves of the same slope look like that by adjusting scale and make it appear that there is along term correlation.

          but, if you adjusted it for inflation, it would look quite different as equity prices would be sloping down from 2000 and the S+P would be 35%ish below 200 levels while profits would still be well up and you would see the curves diverging and realize just how much of that correlation was actually just from inflation.

          • Profits and SP500 are both NOMINAL variables. If both are adjusted for inflation, the pattern in the graph for the two REAL variables is pretty much exactly the same.

          • mark-

            their slopes go into variance and diverge markedly from 2000 if you look at them in real terms.

            the slope of the S+P becomes negative but the slope of earnings stays positive. it looks like you just picked some end points to line up, but the actual relationship of the curves would look quite different in real terms.

            further, you cannot just use earnings. it has to be earning + dividends or else you are only looking at part of the picture and missing that dividend yields have halved.

            if we take the chart you drew from 1990 and add in dividends, then we get (nominally) $35 in 1990 and 132.91 in 2012 a 279% increase vs the S+P which went up 344% and we see that the end points on the chart do not line up as well.

            it’s your scaling etc that i think is a bit misleading as well as the fact that you seem to be using an incomplete metric for yield as an investor would look at earnings + dividends, which, of course, are subtracted from earnings in an income statement before you get to EPS.

          • See updated post with new chart showing the variables adjusted for inflation in 2012 dollars. Nothing really changes except the scale. In each period (quarter), both variables get shifted up the same amount, but the relationships and patterns over time remain basically exactly the same.

        • Oh, I did not read carefully enough, morganovich. Earnings yield should be a meaningless figure for the long term investor. I don’t think it says anything about the yield on the investment he made. It only indicates the very short term yield if his investment was made at exactly that time.

          IMO, Mark’s chart is much more meaningful for the long term investor. But I agree it would be better if it included dividends in addition to price appreciation.

          • mark-

            i do not understand that comment.

            how can the price of the S+P index be adjusted for dividends?

            the S+P index data you put in that graph is just the pure, nominal S+P index value. you can check the numbers against some charting software to see that.

            what is an adjusted S+P index price and how could that include dividends?

    • Couldn’t disagree more. Green shoots are everywhere, have been for 2+ years. They’re only getting entrenched deeper and broader. The market sees this and knows an accomodating Fed (that is nowhere close to overdoing it according to long running log graphs of FoF) will support expanding private markets by providing liquidity sufficient enough to facilitate trade.

      Also, taxes will reign in inflation before the sllightest whiff of it.

  5. Equity investments are risky, inasmuch as they fluctuate rather drastically at times. Mark’s post is a reminder that there are some fundamentals at work. I stayed in after the 2000 crash and the 2007/08 crash and have recouped all my losses and then some. The annualized return for the 10 year period ending in March (with dividends reinvested) is 8.3%.

    • rich-

      perhaps, but that 10 year period is a bit of a cherry pick as it starts at the bottom of the 2000-3 crash.

      start from 2000 and you get a MUCH lower number.

      leaving out dividends, the S+P is only up 87 points from where it closed 1999. that’s a 5.9% gain.

      the dividend yield is more than offset by inflation when you look at real wealth. dividend yields for the S+P have averaged 1.7 ish% since 1999. inflation has been higher, averaging around 2.5%.

      this gap more than wipes out the 0.4% compounded annual nominal gains to the S+P since 1999 and means that if you put $100 in the S+P at the end of 1999 and left it there with dividend reinvestment, it would be worth less in real terms now that it was then.

      the picture gets a bit better if you have been adding money every year in which case you will be up, but if you just put in money in 1999 and left it you are down in real terms, even with reinvestment.

      • morganovich: “start from 2000 and you get a MUCH lower number.”

        Starting from the year 2000 is just as much a cherry pick as starting from 2003.

        morganovich: ” but if you just put in money in 1999 and left it you are down in real terms, even with reinvestment.”

        Only folks who were retired on or before 1999 should have experienced the loss you refer to. But most of the folks who were retired before 1999 also experienced tremendous gains in the 1980s and 1990s.

        • Amen. Some of the returns I got in the 1990′s were absurd. I used the 10 year period because I have seen claims that there has been little gain on the S&P in the last decade.

        • john:

          sure. that was my point. i was pointing out how a start point matters.

          to my mind, the most relevant way to look at the market in terms of the performance of the recent past is to take the current price and then work back until you hit the earliest point we hit a similar value in real terms. from that, one can at least say “the market has not gone anywhere in real terms since X” and avoid cherry picking by selecting the date based on real return.

          this puts you somewhere in 1998 based on the present S+P, so what we can say is that money put into the S+P in 1998 is worth the same in real terms now as then.

          clearly, the actual return an investor got over that period may be VERY different if they were adding money every year and or paying taxes on gains and this rapidly becomes so idiosyncratic that it is not that useful to speak in generalities.

          i’m a big fan of equities and have spent most of my career investing in them.

          my point is just that over the last 12-14 years, the returns to equity investing have been far below the historical norm.

          some of this doubtless has to do with the start point being at the peak of the .com bubble, but the CARR to today even from the trough in 2003 is pretty grim and not even half the historical average of 8%.

          • morganovich: “to my mind, the most relevant way to look at the market in terms of the performance of the recent past is to take the current price and then work back until you hit the earliest point we hit a similar value in real terms. from that, one can at least say “the market has not gone anywhere in real terms since X” and avoid cherry picking by selecting the date based on real return.”

            But how is that not cherry-picking? You are explicitly trying to find a date at which the return is zero. Because the S&P 500 is currently at or near an all-time high, to meet your requirement, you would have to cherry-pick the previous all time high. But if you took a date 24 months before that previous all-time high – or 24 months after that all-time high – the investment return would be significant. So you are, IMO, cherry-picking by using the only real bubble we’ve seen in stock prices over the past three decades.

            In any case, almost no one suddenly invested all their funds in the stock market during the year 2000. So almost no one realized the zero return you seem to be focused on.

          • morganovich: “the CARR to today even from the trough in 2003 is pretty grim and not even half the historical average of 8%.”

            Where do you get that information? According to MS-Money, the 10 year annualized total return for VINFX (S&P 500 index fund) is 8.12%. Google Finance reports the 10 year annualized return for VINFX to be 8.25%.

  6. As a born again liberal, Stockman glosses over LBJ’s Great Society and ignores the beginnings of the welfare state. The HUD disaster of the 1960′s and 70′s was the great beginning of the triad of government, banks and real estate brokers interference in the economy with government guaranteed loans. This was the first great subprime scam. It laid the groundwork for all future real estate and lending scams. With the help of the NAR, home ownership became a right instead of a responsibility. And the first grand attempt at sticking the taxpayers with the mess through HUD foreclosures. The politicians wised up and future scams were financed by the banks, with most of the junk winding up with Freddie and Fannies, again sticking it to the taxpayers. And George W. Bush and Denny Hastert has to take a lot of blame for the current crisis. Bush never saw a spending bill he didn’t like. But the current administration makes the Bush people look like chiselers. Where will it end? Glass-Steagall had nothing to do with investment banks by the way. This is an oft repeated lie by the left. Glass-Steagall only applied to retail banks.

  7. Also, if you want to know if this rally is sustainable, look at revenues. Most of these “profits” are cost cutting measures. Revenues have been going down. Not a good sign.

    • Jorod: “Revenues have been going down.”

      I looked at the revenues of the largest U.S. corporations:

      Yr/Yr Revenue growth %, most recent qtr
      xom -5.3
      wmt 3.9
      aapl 17.7
      gm 3.5
      ge 3.6
      hpq -5.6
      t 0.2
      cvx 0.9
      bac -9.4
      brk 17.8
      mck 1.1
      vz 5.7
      f 5.3
      vlo 0.1
      cvs 10.9
      ibm 0.6
      c -5.7
      cah -6.8
      unh 11.0
      kr 12.8

      Revenue growth for those top 20 corporations averaged 3.1%.

      U.S. Census Bureau Quarterly Financial Reports also show that the sales growth was broad:

      Large retail trade companies: sales in Q42012 up 2.5%
      Manufacturing corporations: sales in Q42012 up 2.2%

      The data I have access to show that revenues are increasing.

      Do you have any real data that show revenues are declining?

        • jorod: “Are they adjusted for acquistions? Or same store sales?”

          Oh, please! Those are year over year figures for the 20 largest companies. Acquisitions were almost non-existent for those giant corporations in 2012.

          You’re just grasping because you really have no data to back up your assertion that revenues are declining for corporate America.

          You lose credibility when you make assertions which you cannot back up with hard facts. Learn that, jorod.

  8. ” if you put up all your own money for a restaurant and then go live large and blow it, well, wasn’t it your money? if you fail, you fail and lose your money. you wind up in a hole, the folks that worked for you got paid.”
    But they usually don’t get paid. The last check bounces and the guy never paid the payroll taxes. There are IRS liens on the property that the bank can’t liquidate until the taxes are paid. And forget it if he was money laundering, you will never get the collateral….

  9. People got tremendous gains in the ’80′s and ’90′s if they took profits. Too many people play “Let it ride..”

  10. Are policy wonks like David STockman still grasping at straws trying to correlate the slow recovery to Fed printing? They always want to crucify those who save them .. Bernanke should be issued the Person of the Century award and voted in as the next POTUS.

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