So here we are.
The GDP of the United States is approaching $18 trillion (17.8 is the most recent estimate, and that is before many forthcoming revisions). That estimate reflects the known effects from the strengthening dollar, which continue. And that estimate accounts for the downward oil price shock. It also follows adjustments for weather-induced first quarter negative changes and a West Coast port strike adjustment.
Domestic profits are a major part of that GDP. They are running about 70% of total profits for US corporations. Foreign-sourced profits are about 30% (Credit Suisse (SIX:CSGN) estimate plus NIPA data).
Using the National Income and Product Accounts (NIPA), we can already discern that corporate profits originating from the rest of the world have been declining as the dollar has strengthened during the last year. The rate of change has gone from positive 4% to about negative 4%. Credit Suisse cites FactSet Earnings Insight, March 20, 2015, for details about Q1 2015:
For companies that generate more than 50% of sales inside the US, the estimated earnings growth rate was 0.0%. For companies that generated less than 50% of sales inside the US, the estimated earnings decline was -11.6%.”
Ok, you ask, what about the Energy sector? Credit Suisse says,
Even when the ailing energy sector was excluded, companies in the S&P 500 with less global exposure were expected to report stronger earnings growth (+5.9%) than those that generate less than 50% of sales inside the U.S. (-1.3%).
So how do we value the US stock market under these conditions?
At its low in the summer of 1982, the S&P 500 traded at about 31% of GDP. (Ned Davis Data; Jim Bianco deserves credit for the concept.) That was more than two standard deviations below the longer-term (100-year) trend. The trend level was about 65 in 1982.
Let me translate that. The trend level of the stock market-to-GDP ratio in 1982 was about 65% if we use the S&P 500 for the stock market and use the final, revised GDP estimates for that year. Since the market was making a major low in 1982, the actual ratio was about 31%. From this we infer that, had the 1982 stock market been priced to result in a ratio of about 100% of GDP, it would have been about two standard deviations above the trend.
What has happened since the 1982 low? We will ignore the 30-year decline in interest rates, the fall of inflation, and the other changes in the world and look only at the market valuation question. All those factors have been quite positive, on balance, but for this commentary we will focus narrowly on the stock-to-GDP ratio.
So, back to stocks. Let’s fast forward to today.
The longer-term trend level of S&P 500 value to US GDP is about 95%. The current level of the S&P 500 is about 105% of GDP. So at first view it would appear that the US stock market is richly priced, but not by very much. But history suggests that analysis may not be really complete.
The range of about 35 points from peak to trough in the ratio of stocks to GDP has held roughly constant for the last century. The 1929 high was an extreme overshoot. The World War II-era, 1942 low was an extreme undershoot; it occurred after Pearl Harbor and before the Doolittle bombing raid on Tokyo. So at today’s 105% we are not much above the range.
But something else has happened since the 1982 low. The foreign-sourced profit share of American corporations has risen from 10% to 30%. Thus an additional 20% of profits now being earned by American corporations originates from their activity abroad. However, US GDP does not include the foreign GDP that is the source of that additional 20% profit share. In other words, our domestic GDP generates only 70% of profits; thus using GDP alone to value the stock market is ignoring the growing foreign GDP that has become very significant.
What can we infer?
Maybe the current level of stock prices is forecasting that the profit share from foreign sources is going to decline abruptly, while the domestic share is not going to grow. That is possible, but we do not see any forces at work to make it happen. Maybe the taxation of American corporations is about to go up significantly so that after-tax profits will decline. That is possible, but we do not see it as likely.
The other side of the argument is that the profit share from abroad will continue to grow, as it has for the last 30 years, and that US corporations will continue to gain global market share. Or, at least, we may infer that they will hold their own. They may gain by acquisitions, as we just saw with Monsanto (NYSE:MON). Or they may gain by market penetration, as we just saw with Apple (NASDAQ:AAPL) in China. How they gain is not the important issue from the perspective of the stock/GDP ratio. As long as they gain, this measure of stock market value remains a critical macro indicator.
If we are close to being right, the adjusted trend for the stock/GDP ratio would actually be below the current level rather than above it. Adjusted for the profit share change, the stock market is cheap, not richly priced. And if the foreign-sourced earnings trend continues upward, the S&P 500 Index could easily reach 3000 by the end of this decade, at a time when US GDP will be about $20 trillion.
If the trends in place for many years continue, foreign GDP will then be providing about 32% of NIPA profits. This is a very rough estimate that includes a guess about how to incorporate currency adjustments.
We remain fully invested in our US ETF accounts. Our strategic view is that the S&P 500 Index can reach the 3000 level by the end of the decade. By the way, if it hits 2700 or 3300, we will be just as right with this forecast – the confidence interval is wide. But the trend is clear, and it is up.
David R. Kotok, Chairman and Chief Investment Officer