Last week’s GDP report caught headlines for the weak economic growth in Q1. But a less-discussed part of the report was the surge in corporate profits in the fourth quarter of 2016.

The corporate profit level had fallen below its long-term average (since 2000) in 2012 and never recovered until 2016.

The actual dollar amount of aggregate corporate profits actually fell between this period, from $1,727 billion in Q1 2012 to $1,679 billion in Q4 2016. Between January 2012 and December 2016, the S&P 500 rose from 1,277 to 2,239, an increase of 75% (to be fair, the corporate profit number measures flows, while the S&P 500 is a time series).

No matter how you slice it, the market continued to rise as corporate profits remained flat. This has led to a very expensive market. According to Robert Shiller’s CAPE ratio, investors are today willing to pay almost $30 per $1 of earnings. The long-term average valuation is $16 per $1 of earnings.

What does this mean for stocks?

On an earnings per share basis, the market is still very expensive. However, corporate profits ultimately determine earnings (companies can’t buy back shares forever). The rise in corporate profits could help the market valuation fall toward its longer-term average.

Over the past few years, the 1-year S&P 500 return was above the annual growth in corporate profits. This is exactly how the market got so expensive. However, in 2016, the two lines converged, and the annual S&P return was actually below the annual growth in corporate profits.

For an expensive market, this is a good signal. The market valuation is based on a ratio: earnings per share (EPS). There are two ways for the EPS to fall to its long-term average. First, the price of shares can fall. Second, earnings can rise while the share price stays flat.

Considering these two alternatives – a market crash or profits playing catch-up – the market is currently trending in the right direction. The market’s valuation will always revert to the mean. Better to do it in a slow and balanced manner than a rip-the-band-aid-off market correction.

This would mean that investors could see lower returns for a few years. But rising corporate profits could lead to a healthier, more normal market.

Photo: Chris Dlugosz, Flickr Commons