Over the past two decades, after-tax corporate profits have climbed to new heights—their share of gross domestic income (GDI) is currently at 9 percent, compared to a historical average of 6.5 percent. Equities investors are wondering whether widening profit margins will become a permanent structural feature of the economy, or if today’s higher earnings will recede as the business cycle matures.
Today’s unprecedented earnings growth has pushed the stock market to record highs. Equities have climbed 17 percent annually on average since 2009, rising far more quickly than GDP. But is this bull market sustainable?
Several factors suggest that it is, and higher earnings will support the stock market’s continued climb.
Beginning in the early 1990s, profit margins began widening and have been steadily climbing ever since. In 2011, after-tax corporate profits captured a record high share of 10 percent of GDI. Cutbacks in the energy sector have tapered earnings in recent years, but profits still account for approximately 9 percent of GDI, well above the 6.5 percent historical average.
This long-term trend toward increased profitability was interrupted by recessions in 1991 and 2008, but never fully changed course. This suggests that the trend is being driven by forces beyond the regular business cycle: Even when the labor market has tightened and contracted, earnings have continued to rise.
If higher earnings are a cyclical feature that will fade as the business cycle matures, then the stock market could shed as much as 25 percent of its current valuation when profits eventually fall back to their historically normal range. But if structural forces are creating a new normal for higher corporate profits, today’s bull market reflects reasonable expectations about future earnings.
Wider profit margins are largely due to the emergence of super-efficient, highly profitable superstar firms that dominate their sectors. Thanks to increasing efficiency from advancements in automation and artificial intelligence, the rising share of the economy going to corporate profits may reflect a permanent structural shift. It’s hard to imagine that the past two decades’ progress in these areas will be reversed; rather, these changes suggest a fundamental alteration in the composition of the economy.
The stock market has been slow to fully price in the implications of rising profitability. The bursting of the dot-com bubble in the early 2000s left equity investors cautious, restraining the market’s average price-earnings ratio for most of the decade. Over the past eight years, however, investors have gained confidence in the durability of higher earnings.
Despite the market’s tremendous rise since 2009, the average stock’s price-earnings ratio has only recently risen back into alignment with the ratios seen during the peak years of past expansions. From this perspective, the bull market has been playing catch up and is only now approaching a fully valued state.
The market has created approximately $6 trillion in new wealth over the past year. As investors begin to view higher valuations as the new normal, they are likely to start spending their capital gains windfall.
The durability of corporate profits also translates into concrete gains in American household portfolios. The market has created approximately $6 trillion in new wealth over the past year. As households begin to view higher valuations as the new normal, they are likely to start spending their capital gains windfall. That could lead to 1 to 2 additional percentage points of GDP growth over the coming year.
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