On Thursday, the Commerce Department made a slight downward revision in GDP for the 1st Quarter. The agency reported that the economy grew at an annualized rate of 2.4%, instead of the previously reported 2.5%. Buried in the data, however, was far more troubling news. Corporate profits after taxes dropped 1.9% last quarter. Economists had expected a slight increase. The contraction in profits is a bad sign for the economy.
Profits from current production (corporate profits with inventory valuation and capital consumption adjustments) decreased $43.8 billion in the first quarter, in contrast to an increase of $45.4 billion in the fourth.
Despite rhetoric from the left, profits are the fuel for economic growth. They allow firms to invest and expand and they provide shareholders with income. They also provide the foundation for valuations on the stock market.
We’ve recently completed earnings season on Wall Street, when publicly traded companies report their quarterly earnings. Earnings of S&P 500 companies were up a tepid 3.7% for the year, but overall revenue was down 0.2%. With sales down, companies earned profits on cost-cutting. So much, in fact, that company margins are 70% higher than their historical norm.
This is not sustainable.
The stock market has been in bullish territory lately, with the Dow staying comfortably above the 15,000 level. The media often use the market as a proxy for the overall economy and have used its rise to trumpet the notion that the economy is experiencing a strengthening recovery. The 1st Quarter decline in corporate profits runs counter to this narrative.
One way to look at stock valuations is the Shiller PE index, which looks at a decade of earnings and adjusts for inflation. Stocks are currently trading around a multiple of 24, meaning the stock price is 24X a company’s earnings. Historically, stocks have traded at a multiple of 16.
Much of this higher valuation is due to liquidity pumped into the economy by the Federal Reserve. In theory, the central bank’s actions are meant to provide a bridge until the underlying economy recovers and begins to grow again. That theory isn’t working out, however.
This movie will not end well.