Monday, March 21, 2016

Next major profit margin move may be downwards

Investing Myth:  Stocks Are Superior Investments In The Long Run

They are indeed because of long-term economic growth and the parallel growth in gross corporate product, which is essentially corporate sales. Although other sectors of the economy, such as unincorporated business, government spending and financial transactions, are significant, corporate revenues are involved in most aspects of the economy and therefore closely linked to GDP. In the post-World War II era, nominal GDP grew at a compound rate of 6.49% while GCP rose about the same rate, 6.66%.

In the long run, corporate profits rose at about the same rate as nominal GDP and GCP as revenues, after deducting costs, dropped to the bottom line. In the 1947-2015 years, corporate profits as defined by the Commerce Department, rose at a 6.74% annual rate and 6.11% for S&P 500 earnings.

That S&P reported earnings gain was below both the growth in GDP and GCP, which is puzzling because of the upward survival-bias in the S&P 500 index that we’ll discuss later. Also, you’d expect earnings by any measure to grow faster than the economy due to operating leverage as sales rise and spread fixed costs over more units of output, to say nothing of financial leverage. And financial leverage as reported on corporate balance sheets will be increased by new regulations requiring companies to add to their liabilities their huge leases on real estate, airplanes, office equipment, etc., which are effectively debt. Furthermore, the corporate sector’s share of GDP has grown on balance in the post-World War II years.

As a residual, profits—the difference between corporate revenues and costs—are obviously volatile. So, on a short-term basis, the growth in Commerce Department corporate profits and S&P reported earnings per share varies widely from the rise in nominal GDP. Profits are also influenced by the trade-off between the share of national income received by business and that which goes to employee compensation. In a democracy, neither labor nor capital gets the upper hand indefinitely, so the two shares swing from one extreme to the other as mirror images.

Real economic growth has been very slow and inflation absent, with deflation reigning in the goods sector. So the normal source of profits gains, revenue growth, has been missing with little unit volume growth and no pricing power.

In response, American business slashed costs, which spurred profits’ share of national income, a measure of the nationwide profit margin. Since most business costs—directly or indirectly—are for labor, employee compensation’s share saw a mirror image fall. But while profit margins remain on a record-high plateau, advances stopped several years ago. It remains to be seen whether business has scraped the bottom of the cost-cutting barrel or has picked all the fruit and has to wait for more to ripen. History however, suggests that the next major move in profit margins will be down.

Still, in the long run, the growth rates for nominal GDP and profits are similar. This means that over time, stock prices ride up with nominal GDP—except for the price-earnings ratio that converts earnings into equity prices. In effect, long-only stockholders are relying on a rising economy, which makes it a plus-sum game, on average. But beyond the average result, it is a zero-sum game. Anytime that investors who outperform the market gain, underperformers lose. After all, the average performance is the average. I doubt that many individual investors and probably lots of institutional investors understand the simple reality that the stock market isn’t like Garrison Keillor’s Lake Wobegon where all the children are above average.

via forbes