As the markets push once again into record territory the question of valuations becomes ever more important. While valuations are a poor timing tool in the short term for investors, in the long run valuation levels have everything to do with future returns. The reason I bring this up is that in 2013 reported earnings per share for the S&P 500 rose by 15.9% to a record of $100.28 per share with roughly 40% of that increase occurring in the 4th quarter alone. That late surge in corporate profits was a bit of a surprise as estimates had been lowered going into the end of last year. The question, however, remains the ongoing sustainability of that growth rate of earnings going forward. John Hussman, via Hussman Funds, made an interesting point in this regard in a recent note:
“I’ve noted frequently that after-tax corporate profits as a share of national income are about 70% above historical norms; that these profit shares are heavily mean-reverting and strongly (inversely) associated with subsequent profit growth over the following 3-4 year period; and that the current surplus of corporate profits is the mirror-image of corresponding deficits in household and government savings (a relationship detailed in prior weekly comments). Recent profits data, as well as the entire historical record, are tightly explained by these factors.
Notably, this data is derived from the national income accounts computed by the Bureau of Economic Analysis, and it’s worth understanding how the BEA computes profits. Specifically, the BEA points out, ‘Because national income is defined as the income of U.S. residents, its profits component includes income earned abroad by U.S. corporations and excludes income earned in the United States by foreigners.’â€
The chart below shows corporate profits, per the BEA, divided by GDP.  (You can substitute GNP but the result is virtually identical between the two measures.)
