Corporate profits

Corporate profits are historically extreme

I recently discussed the valuation report published by the Office of Financial Research, which contained several important statements about the risk to investors in overvalued markets. To witness it:

“Markets can change quickly and in unpredictable ways. When these changes do occur, they are greatest and most damaging when asset valuations are at extremely high levels. High valuations have important implications for expected returns on investments and, potentially, for financial stability. “

There was one graph in particular that really caught my eye, which was the ratio of corporate profits to GDP.

There are a few important points, in particular, to remember from the table above. First, historically corporate profits have hovered around the long-term average of around 6%. This makes perfect sense, as corporate profitability reflects real economic growth which has increased by roughly the same amount as shown in the graph below.

GDP growth

Second, at two standard deviations from the long-term mean, it is clear that corporate profitability has reached historic extremes, which suggests that a reversal is probably closer than not.

It is important to note that the increase in corporate profitability has not been a function of equivalent increases in revenue growth, but rather of increases in “financial engineering” from changes in accounting rules to massive share buybacks. However, the profitability generated by “financial engineering” is illusory, which is why despite the surge in corporate profits, employee compensation has fallen. The graph below is the ratio of wages to corporate earnings.

Company profits wages
Company profits wages

What is important to note is that the acceleration in corporate profits is due to two main factors; deregulation and expansionary monetary policy. As stated on Monday:

“Generally speaking, systemic crises tend to be preceded by bubbles in one asset class or another. Brunnermeier and Schnabel identified four factors that accelerate the emergence of asset bubbles: expansionary monetary policy, credit booms, influx of foreign capital and financial deregulation.

They concluded that bubble funding is much more relevant than the type of asset bubble, noting that “stock market bubbles can be just as dangerous as real estate bubbles if the funding goes through the fi nancial system.” They also noted that the ripple effects of bursting bubbles are most severe when accompanied by a credit boom, high leverage, and liquidity mismatches among market players. Marlet. “

I the growing detachment between the stock market and the “real” underlying economy. One of the areas I touched on was corporate profits which were boosted by an immense amount of accounting gimmicks, cutting costs, and increasing productivity. The problem, like I said, is that historically earnings have gone up 6% peak to peak before rolling back. Notice, I said tip to tip. The problem is, the majority of analysts now believe earnings will rise steadily over the next five years.

As shown in the chart below, the dashed red line indicates where earnings currently stand relative to expectations. Second, profits never reached the currently expected growth rate … never.

Business profits

As Jeremy Grantham once said:

“Profit margins are probably the most negative streak in finance, and if profit margins don’t revert to the mean, then something has gone wrong with capitalism. If high profits don’t attract competition, there is something wrong with the system, and it isn’t working properly. “

Grantham is right. As noted, when we look at inflation-adjusted profit margins as a percentage of inflation-adjusted GDP, we see a clear process of reverting activity to average over time.

Adjusted profit margins

Reversals occur from both peaks and troughs. Therefore, when profits to GDP have significantly exceeded their long-term average (1 or 2 standard deviations) there was a subsequent return. (To note: the chart above is real, earnings adjusted for inflation and inflation relative to real GDP, as opposed to the OFR chart which was on a nominal basis.)

Corporate profit margins have physical constraints. For every dollar of income created, there are costs such as infrastructure, R&D, salaries, etc. Currently, one of the main beneficiaries of the increased profit margins has been the suppression of job and wage growth and the artificial suppression of interest rates which have drastically reduced borrowing. costs. If any of the issues were to change in the future, the impact on profit margins would likely be significant.

However, there is another compelling story that tells us about the inflation-adjusted earnings-to-GDP ratio. The graph below shows the ratio superimposed on the index.

Business profits vs.  The S&P 500
Business profits vs. The S&P 500

I have highlighted the peaks in the earnings-to-GDP ratio with the vertical blue bars. As you can see, spikes and subsequent reversals in the ratio have been a leading indicator or more severe reversals in investment markets over time. This should not be surprising as asset prices should eventually reflect the underlying reality of corporate profitability. However, since asset prices are driven by emotion rather than logic, this explains the mismatch between fundamentals and investor awareness that “This time is NOT different.”

As noted above, balance sheet manipulations have been the main contributors to the increase in profitability. However, these actions are finite in nature and the profit making process has cannibalized consumer income. Stagnant wage growth, combined with the rising cost of maintaining the current standard of living, has resulted in a decrease in the ability to generate sales gains that exceed population growth. This is a big part of why, which doesn’t increase real incomes, hasn’t translated into increased retail sales.

For now, the bull market is raging as hopes of the central bank’s continued stimulus dance playfully through investors’ heads. Eventually, the current disconnection between the economy and the markets will merge and as the OFR concluded in yesterday’s report:

“Today, many market strategists see the bull market expand throughout 2015. However, Quicksilver’s markets can quickly turn from quiet to turbulent. It should be noted that in 2006 volatility was low and companies were generating record profit margins, until the cycle came to a screeching halt due to events many people did not anticipate. history shows that high valuations come with inherent risk. Based on the preliminary analysis presented here, the implications of a market correction on fi nancial stability may be moderate due to the limited transformation of liquidity in the equity market. However, the potential financial stability risks resulting from leverage, compressed pricing of risk, interconnectivity and complexity merit further attention and analysis. “