A Profit "Recovery" Driven By Plunging Labor Costs Explains Why PE Multiples Will Remain Depressed

Tyler Durden's picture

In addition to the traditional (and much discredited) argument of quadrillions of cash on the sidelines (which conveniently ignores the quintillions of debt also on the sidelines), the other last remaining point that bullish pundit like to point out is that the PE on the S&P is oh so very low compared to historical level. Putting aside the fact that the last 30 years of economic data have been perverted by a cost of credit which has declined from 15% all the way to zero, and with no additional place to go, and as such any historical comparisons are now moot as the Fed is pretty much out of options (aside from monetizing of course, and outright debasing the dollar), the primary reason why investors continue to put little credit in the "miraculous" corporate profits explosion, and thus give companies subpar P/E, is that the entire profit recovery has been predicated not on GDP growth (which explains the constant skittishness about macro events), but on declining labor costs, and as the following JPM report points out, "the latest profit recovery (the three red dots) is reliant on declining labor costs like none before it." What investors really want to know is how much more wage deflation can America take before it all collapses into a huge stinking deflationary mess? And by sowing the seeds of deflation at the heart of the corporate economy, who in their right mind would expect a wage-driven inflation (a monetary-event catalyzed hyperinflation, in which the Fed just goes berserk and decides to print $1 quadrillion tomorrow, is a different topic altogether).

More from JPMorgan:

These deflationary trends surface some important questions about corporate profits, which have beaten expectations for the last 5 quarters. As shown below, a proxy for profits (nominal GDP growth less unit labor costs) is growing at a healthy clip, which usually indicates recovery rather than recession. But let’s decompose this profit proxy for a moment, looking specifically at periods when it’s rising faster than 5%. Most of the time, a profit proxy of 5% or more reflects healthy nominal GDP growth in excess of still-rising unit labor costs. But the latest profit recovery (the three red dots) is reliant on declining labor costs like none before it. A profit recovery whose foundation is so reliant on sustained high productivity and low real wage growth should not command a very high P/E multiple.

So the next time some permabull tells you P/E multiples are low, low, low, tell them that they are only low as the alterantive would be to be bidding up corporates in a deflationary environment, which in a Catch 22 loop, becomes even more deflationary precisely due to this record profitability. Perversely, investors would gladly pay for much bigger PE's if companies actually paid bigger wages to more people. But they continue to refuse to... and so that whole conversation is moot.