Is this as good as it gets? Has perfection in corporate profits come and gone? Anxious investors with above-average allocations to domestic equities can be forgiven for asking such questions these days. Perfection, after all, has nowhere to go but down.
As The New York Times observed in a front-page story today, corporate profits as a share of the economy, at 10.3% in this year’s first quarter, are the highest since the mid-1960s. The story quoted UBS research, which termed the recent level of corporate profits as “the golden era of profitability.”
Can a golden era remain golden indefinitely? Or is the natural course one that will turn gold into lead? These are the questions that weigh on equity investors, who are sitting on tidy gains generated since the stock market collapse of 2000-2002. For those who were lucky enough to time the subsequent rebound in stocks just right, the ensuing gains have been sweet. The S&P 500 boasts a torrid 15% annualized total return from March 1, 2003 through July 31, 2006. That’s about 50% higher than the stock market’s long-term average performance. Small-cap stocks have enjoyed even stronger performance. The Russell 2000’s total return over the same stretch is nearly 23% a year.
Bull markets for stocks, in other words, don’t get much better than the previous three years or so. But with clarity on economic and political issues receding by the day, a bit more caution on the future may be just the thing to calm one’s nerves.
Don’t misunderstand. We like stocks. We like them a lot. Some of our favorite portfolio holdings are equities. In fact, we’re committed to holding equities as a long-term proposition, come hell or high water. But we’re also inclined to think that the last three years may be anomalous compared to what’s coming for U.S. stocks overall, i.e., a stretch of mediocrity. In turn, our expectations (flawed though they may be) inform our thoughts on equity allocations, which for the moment we prefer to ratchet down.
Trimming back on equities for some may look premature. The rear-view mirror is nothing if not impressive, casting a bullish aura for those who like to extrapolate the past into the future, no questions asked. Earnings, after all, have been the great power that’s elevated stock prices in recent years, and on that measure there’s much to celebrate by looking back. The Federal Reserve saw fit for several years prior to June 2004 to lower interest rates to levels that, with the benefit of hindsight, were excessively low. And even once the Fed started raising rates, it did so slowly, allowing cheap money to endure. Corporate America, being a for-profit group, took advantage of the situation and proceeded to repair balance sheets to a degree that was as dramatic as it was quick.
Consider that in 2001, income before taxes for nonfinancial businesses fell more than 5% from the previous year to $1.15 trillion, according to date from the Fed’s current Flow of Funds Accounts of the United States. However, as the chart below shows, corporate income has been climbing ever since. In fact, last year, income advanced nearly 23% over 2004, making the year one of the more remarkable 12-month stretches in corporate history.
Curiously, the stock market reacted rather sheepishly, with the S&P 500 climbing only 4.9% last year. Perhaps it’s not so curious after all. The stock market is widely credited with looking ahead. Sometimes it sees things that don’t materialize, but in 2003 and 2004 its powers of prognostication were prescient, or so the S&P’s 29% and 11% total return for each of those years, respectively, suggests.
Indeed, earnings continue to impress relative to the past. But the fuel that powers those earnings–rising corporate income–is showing signs of slowing. For this year’s first quarter, corporate income slowed considerably relative to the year-earlier quarter, rising by 13%, as the chart above reveals.
Granted, there’s a big difference between slower rates of growth and outright declines. But for those who think strategically, the signs of income growth turning sluggish are a warning.
No, it’s not time to write off equities and go to cash. Far from it. But pulling back, taking some profits seems eminently reasonable at the moment. Asset classes never go bankrupt, but they do fluctuate. Exploiting those fluctuations and redeploying profits is the only way to fly.