By BRETT ARENDS
President Obama has been pounded for four days for his offhand remark that the "private sector is doing fine."
The jobs picture, of course, remains weak all around. But for investors, at least, the President's comment is on the money. And that's both a puzzle and a reason for caution.
The attached chart shows U.S. corporate profits as a percentage of gross domestic product. The data comes from the U.S. Commerce Department. Profits, as a share of GDP, have not been higher since official records began in 1940. They averaged 7.5% of GDP under Ronald Reagan. In Obama's first three years they have averaged 11.7%. Last year they hit 12.9%.
Last year, the U.S. Commerce Department says, corporate profits totaled $1.9 trillion (before tax, but after accounting for certain inventory and capital issues). That's $6,500 for every American citizen. In 1999, at the peak of the great 1990s boom, they were $3,000 per citizen.
There are other ways of looking at the health of the owners of capital such as profits as a share of corporate gross value added, or compared to labor compensation but they show substantially the same thing.
Howard Silverblatt, senior analyst for Standard & Poor's Indices, reports that the after-tax earnings of the S&P 500 the top 500 companies on the stock market - hit a new record in the first quarter. "They're at an all-time record high," he says. The previous records were in the second and third quarters of last year. They're about 7% higher than at the peak in mid-2007.
Forget "doing fine." As the board member in that fabulous Coen brothers' flick The Hudsucker Proxy observes, "In short we're loaded."
No wonder the stock market boomed over the past few years. Profits induce euphoria among investors, who assume the party will continue forever. And as a practical matter corporations are using a lot of that money to buy back their own stock.
So what's the problem?
Alas, what goes up so often comes down. Indeed when it comes to corporate profitability, that has always been the case. As Andrew Smithers, the financial consultant and author of Valuing Wall Street, likes to say: Corporate profitability is "strongly mean-reverting."
Predicting the future is, of course, a sucker's game, so no one can say for certain how or when things will turn. Maybe it will be a stronger dollar caused by the economic woes in Europe. Maybe it will be a recovery in the U.S. jobs market, driving up wages. Maybe it will be Chinese inflation, also leading to higher wages. Maybe it will be "austerity" in Washington: When the federal government eventually starts reining in those deficits, that will reduce cashflows elsewhere in the economy, and corporate income should fall.
Salesmen on Wall Street will tell you the S&P 500 is "cheap" because it is only about 13 times forecast earnings. Yet, as just noted, those earnings are at record highs. If they come back down to average levels in due course, this market will turn out to be more expensive. Robert Shiller, the finance professor at Yale, prefers to compare share prices to the average earnings for the past ten years. It's a formula first pioneered by the value investment gurus Ben Graham and David Dodd. On this measure, Wall Street is now about 20 times earnings. Historically, the average has been 16 times. So today we're about 25% overvalued.
What does this mean for you? It suggests longer-term returns are going to be considerably lower than in the past.
What makes me most nervous, however, is the blase attitude many are taking towards U.S. stocks. The consensus at the moment is that Europe is completely finished, the wheels are coming off China, Japan might as well not exist, while U.S. stocks are in the sweet spot. Wall Street, in its usual fashion, is predicting the future on a spreadsheet by clicking and dragging from the most recent past. "U.S. equities remain a big overweight position," reported Merrill Lynch Bank of America in its latest monthly survey of institutional money managers around the world. In total, a net 26% of institutions have more U.S. equities than their benchmarks. Given that the global stock benchmarks already overweight U.S. equities for historic reasons, this suggests it is a very crowded trade.
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