It's now an open secret that US companies were not as profitable as they were imagined to be during the boom years. The big question is just how big was the difference, it is this problem more than any other that is currently besetting the equity markets. Morgan Stanley's chief US equity strategist Steve Galbraith has been doing his sums and has calculated that the S&P 500 companies had operating earnings of 4.1% of GDP on average between 1996-2001. The normalized valuation of the S&P companies could be around 17 times earnings, which would put the index's market capitalization at 70% of GDP and the index's value, at 800. But as Andy Xie points out:
Recent information, however, casts serious doubt on the reliability of corporate earnings in the late 1990s. The reported operating earnings of S&P 500 companies were only 2.6% of GDP between 1990-95. The rising share of foreign earnings explained only 0.8% of the increase in the earnings-to-GDP ratio. Was the earnings rise as a share of GDP in late 1990s mainly an accounting phenomenon? Should the earnings picture of the early 1990s be the standard?
The answer to this question may determine how low S&P 500 can go. If sustainable corporate earnings are 3.2% rather than 4.1% of GDP, the S&P 500 index could fall to 625 at 17 times earnings. If bear market sentiment depresses valuation to 14 times earnings -- not uncommon in previous bear markets -- the S&P 500 could fall to 515, or 39% below last Friday's close. That would put the index's market capitalization at 45% of GDP, similar to the level of the early 1990s.
Source: Morgan Stanley Global Economic Forum
Or put another way there is still plenty of room to go down some. Not only this. If it is true that corporate earnings were nearer say 3.2% of GDP, then a big balance sheet adjustment is underway, and this itself is likely to have its own consequences on equity values and capital expenditure. Which all means that we may be nearer a double dip than most like to admit, not to mention the inevitable knock-on effects on the productivity numbers from all this downward adjusting.