Price/earnings valuations are only as believable as the earnings component. Many analysts say that the rebound in profits has been driven entirely by cost cutting, and is of correspondingly low quality. We disagree.
Residents of the United States, please read this important information before proceeding
Please read this important information before proceeding.
Cost-driven profits growth, like an over-borrowed US economy and a QE-driven recovery, is a financial fable.
Revenue growth is clearly visible even in the economic data. Nominal GDP in the US is currently 16% higher than at its crisis low in 2009 (and 12% higher than its 2008 pre-crisis peak). The pay bill (jobs and wages together, US Inc’s biggest cost) has grown by roughly 11% since its low. Even the UK and eurozone’s nominal economies are 14% and 7% bigger respectively than at their crisis lows, and their pay bills will have grown since then.
The rebound in corporate profits may be more durable than many seem to think
The financial sector has been the biggest contributor to the rebound in US profits (and in the UK, but not continental Europe, where financial earnings were hit later, and have yet to recover). We estimate that roughly a third of the approximately $60 rebound in four-quarter S&P operating earnings has come from the financial sector. This will have had little to do with cost cutting, and a lot to do with the predictable end of asset write-downs.
Arguably, because financial profits have played such a big but predictable role in the recovery to date, and overall recovery has been accompanied both by some revenue growth and by falling leverage, the plausibility of current profitability may if anything be underestimated.