Evan Soltas
Feb 18, 2012

America, Undervalued

The bullish case for equities, plus a few asterisks and question marks

Economists are loath to analysis of financial markets, particularly "stock picking"--refer to the post I wrote on the efficient market hypothesis last month--but let me just sound a brief bullish note.

We're now in an increasingly positive macroeconomic environment: falling unemployment numbers, rising GDP growth and hiring, to name a few. (I'm not blindly bullish, of course, and I still think conditions clearly merit further monetary accommodation, but the New York Fed's convenient dashboard of indicators is rather clearly pointing up, after some shaky moments in mid-2010 and 2011.)

Besides home prices, though, which remain low, despite historically low and falling stocks of available homes, I think there's one other driver of economic recovery which has been underwhelming: equity markets.

Yes, there are plenty of reasons to think that investors are marking off some sort of discount on account of macroeconomic risks--Europe is a big question mark, for one, and we are after all emerging from the worst recession since the Great Depression, so "you never know"-style caution is understandable.

But still. The chart above, of corporate profits (after taxes, inventory value adjustment, etc.) against the value of the S&P 500, stands for itself in terms of the argument that American equities are significantly undervalued (read: above 1500 on the S&P), given the record profitability of American corporations and a decent outlook. (Bloomberg is reporting Blackstone saying as much, too.)

Another caveat: I do see a case that recent corporate profit growth is unsustainable. Certainly, I don't expect the sharp gains seen in 2010 to continue ad infinitum. But beyond that, there is a place for concern that these profits came from cost-cutting, and we're now at the bone. It's about demand recovery now, if we are going to see higher corporate profits.