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50% Profit Growth And Historical Realities

Tyler Durden's picture




 

Submitted by Lance Roberts of STA Wealth Management,

As the markets push once again into record territory the question of valuations becomes ever more important.  While valuations are a poor timing tool in the short term for investors, in the long run valuation levels have everything to do with future returns.  The reason I bring this up is that in 2013 reported earnings per share for the S&P 500 rose by 15.9% to a record of $100.28 per share with roughly 40% of that increase occurring in the 4th quarter alone.  That late surge in corporate profits was a bit of a surprise as estimates had been lowered going into the end of last year.  The question, however, remains the ongoing sustainability of that growth rate of earnings going forward.  John Hussman, via Hussman Funds, made an interesting point in this regard in a recent note:

"I’ve noted frequently that after-tax corporate profits as a share of national income are about 70% above historical norms; that these profit shares are heavily mean-reverting and strongly (inversely) associated with subsequent profit growth over the following 3-4 year period; and that the current surplus of corporate profits is the mirror-image of corresponding deficits in household and government savings (a relationship detailed in prior weekly comments). Recent profits data, as well as the entire historical record, are tightly explained by these factors.

 

Notably, this data is derived from the national income accounts computed by the Bureau of Economic Analysis, and it’s worth understanding how the BEA computes profits. Specifically, the BEA points out, 'Because national income is defined as the income of U.S. residents, its profits component includes income earned abroad by U.S. corporations and excludes income earned in the United States by foreigners.'”

The chart below shows corporate profits, per the BEA, divided by GDP.  (You can substitute GNP but the result is virtually identical between the two measures.)

Corporate-Profits-GDP-030414

The current levels of profits, as a share of GDP, are at record levels.  This is interesting because corporate profits should be a reflection of the underlying economic strength.  However, in recent years, due to financial engineering, wage and employment suppression and increase in productivity, corporate profits have become extremely deviated.

This deviation begs the question of sustainability.  Currently, according to the S&P website, reported corporate earnings are expected to grow by 20.26% in 2014, and by an additional 20.28% in 2015.  In total, reported earnings are expected to grow by almost 50% ($100.28/share as of 2013 to $147.50/share in 2015) over the next two years.

If we assume that these projections are accurate, and we assume a continued growth rate of 2% annually in the economy (as has been witness the average since 1999) we can put the current environment into perspective.  The chart below shows real, inflation adjusted, GDP and reported earnings, both actual and estimates, through 2015.

S&P-500-Earnings-GrowthvsEst-030314

I also notated the previous earnings trendline estimates that existed prior to each market peak.  

The sustainability of corporate profits is dependent on two primary factors; sustained revenue growth and cost controls.  From each dollar of sales is subtracted the operating costs of the business to achieve net profitability.  The chart below shows the percentage change of sales, what happens at the top line of the income statement, as compared to actual earnings (reported and operating) growth. 

S&P-500-AccountingMagic-030414

Since 2000, each dollar of gross sales has been increased into more than $1 in operating and reported profits through financial engineering and cost suppression.  The next chart shows that the surge in corporate profitability in recent years is a result of a consistent reduction of both employment and wage growth.  This has been achieved by increases in productivity, technology and offshoring of labor.  However, it is important to note that benefits from such actions are finite.

Wages-to-Profits-030414-2

As asset prices continue to surge higher in hopes of an "economic revival," the question of "sustainability" of corporate profitability looms large.

As John Hussman concludes:

"Given the economic landscape of recent years, large offsetting sectoral deficits and surpluses are not surprising, but they should not be taken as evidence that the long-term profitability of the corporate sector has permanently shifted higher. Stocks are not a claim to a few years of cash flows, but decades and decades of them. By pricing stocks as if current profits are representative of the indefinite future, investors have ensured themselves a rude awakening over time. Equity valuations are decidedly a long-term proposition, and from present levels, the implied long-term returns are quite dim.

 

The chart below (CPATAX/GNP) provides a good summary of the present situation, and a reasonable sense of what we expect for corporate profit growth over the coming several years."

Profit-Growth-GNP-ForwardGrowth-030314

As we know from repeatedly from history, extrapolated projections rarely happen.  Could this time be different?  Sure.  However, believing that historical tendencies have evolved into a new paradigm will likely have the same results as playing leapfrog with a Unicorn

There is mounting evidence, from valuations being paid in M&A deals, junk bond yields, margin debt and price extensions from long term means, "irrational exuberance" is once again returning to the financial markets.  However, that does not mean that a mean reversion process in imminent.  It was in 1996 when Alan Greenspan first uttered those famous words, it was 4 years later before investors regretted not paying attention them.  It is likely that the same will be true this time.  With the Federal Reserve still pushing liquidity into the markets, there is little to deter the "bullish bias" presently.  However, as John noted above, investors that fail to heed the warning signs will likely ensure themselves a rude awakening over time

 

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Tue, 03/04/2014 - 16:28 | 4508682 NOTaREALmerican
NOTaREALmerican's picture

 

It's totally different now:

1)  Perpetual free money

2)  Bottom 80% no longer need to have jobs to consume.  

3)  If I can sell every Chinaman one _________ (fill in widget) I'll be a bazillionaire.

Tue, 03/04/2014 - 16:30 | 4508699 Shizzmoney
Shizzmoney's picture

I think you can 100% correlate the declining "Wages to corporate profits" graph with the "Declining American Morale" graph

And people wonder why they want to start war

Tue, 03/04/2014 - 16:33 | 4508709 LawsofPhysics
LawsofPhysics's picture

This is what you get when your monetary system is completely detached from reality and fully manipulated by a relative few.

The real problem of theft and fraud remains.

hedge accordingly.

Tue, 03/04/2014 - 16:33 | 4508710 khakuda
khakuda's picture

Once again, the Fed has NO idea of the bubbles they are engendering.  None.  The next 30% move to the upside will guarantee the inevitable decline.  Soon to be 6 years of manipulating markets with no end in sight.

Idiots.

Tue, 03/04/2014 - 17:03 | 4508899 NOTaREALmerican
NOTaREALmerican's picture

Re:  Soon to be 6 years of manipulating markets with no end in sight.

When we pass 15 years of manipulation it can no longer offically be called manipulation.  

The 15 year market rule applies here.

Tue, 03/04/2014 - 16:35 | 4508730 ejmoosa
ejmoosa's picture

What you really want to look at is the rate of year over year profit growth.  And it has been slowing for three consecutive years.

Year over year

As of 9/2013 : 3.73%

        9/2012:  8.53%

        9/2011:  9.88%

        9/2010: 33.49%

(Corporate profits as reported by the BEA which includes all US businesses)

Under 7-8% and we head into a recession, to right size to the new economic realities.

 

We are in this to grow profits, not make the same as a year ago.

 

Tue, 03/04/2014 - 16:37 | 4508747 mayhem_korner
mayhem_korner's picture

 

 

Irrational exuberance is also the goal of viagara and SSRIs.  That's the world in which we live.

Tue, 03/04/2014 - 16:37 | 4508750 Duc888
Duc888's picture

 

 

 

 

Profit?

 

Really?

 

What will these profits buy as food and fuel are inflated?

Tue, 03/04/2014 - 16:39 | 4508763 Duc888
Duc888's picture

 

 

Shizzzmoney "And people wonder why they want to start war"

 

The Fed has weaponized money and they are conducting warfare as I type this.

Tue, 03/04/2014 - 16:54 | 4508848 Rainman
Rainman's picture

The eCONomy is a financial Frankenstein !

" About 32% of seriously delinquent borrowers ( anywhere from 3 to 6 million homes ), those that are at least 90 days late , haven't made a payment in more than 4 years, up 7% from 2012."

          Shawn Nelson, Analyst , Fitch

Tue, 03/04/2014 - 18:19 | 4509301 Element
Element's picture

Yeah but look at the 20 year trend in fig.2. ... it's up baby!

Robo was right!

Charlie don't surf volatility ... lol 

BTFD!!!

Tue, 03/04/2014 - 17:01 | 4508882 29.5 hours
29.5 hours's picture

 

 

Equity valuation, eh? Sounds so reasonable. However, if a great power altercation in Europe does not budge markets from record highs (as they did not) then one can only conclude that equity valuations have a steady foundation and almost boundless future.

 

 

Tue, 03/04/2014 - 17:18 | 4508995 delivered
delivered's picture

Please remember the following and act accordingly:

- Corporate profits are easy to engineer through the use of changing accounting "estimates" for reserves, goodwill, intangible assets, etc. I bring this up as I believe the above analysis would be more relevant if it excluded the financial industry/segment (which has had required mark to market accounting regulations relaxed). 

- Remember, cash flow is king, period! Operating income, EBITDA, and net income can all be easily manipulated when the foxes (Wall Street, CEOs, etc.) are in control of the hen house (accoutants). That is the current situation as in today's world, non-GAAP earnings are now more important (and hyped more) than GAAP. The best measurement is not corporate net income but corporate free cash flow.

- Agreed on the M&A world. I've supported roughly $100 million of smaller M&A deals since mid 2012. Not only are price/vaulations very high but deal structures are very liquid (almost all cash/public stock). With higher deal values, the left side of corporate balance sheets as it relates to valuing IP/Goodwill get distorted so balance sheets are being supported by a lot of "hot air" right now. 

- The rule is simple, when stupid money comes to the party its getting close to turning out the lights. I'm seeing more and more stupid money flow into deals which are highly questionable. The stupid money that's punch drunk always comes too late but remember, the bar usually finds a way to stay open a little while longer to extract the final money.

So where are we, my guess is that it's about midnight at the bar which stays open until 2:00 AM. So we have a couple of hours left for the really drunk and stupid money to party a little while longer and run up tabs that will come due soon enough. Just no way to justify some of these values but to go short now scares the shit out of me. With all of the world's problems, all of the economic data pointing to slower growth, and consumers taking on more and more debt that cannot be repaid (as lenders move into sub-prime markets), you would think the market would begin to price this in. Yet every day is a new high? Just no way to explain this any more other than comparing it to the punch drunk parties that crashed hard in 2000/01 and 2008/09.

Tue, 03/04/2014 - 17:42 | 4509134 Rainman
Rainman's picture

Sounds about right. The Big 4 public accounting firms aren't even bashful about their bagman status. The accounting corruption is both sanctioned and institutionalized.

Tue, 03/04/2014 - 17:55 | 4509178 venturen
venturen's picture

this is what happens when you print trillions and give it to the very criminals that broke the system!

Tue, 03/04/2014 - 17:52 | 4509184 venturen
venturen's picture

So it is true...liberal scum like Obama and his cronies...reward the rich by taking from the middle and poor

Tue, 03/04/2014 - 19:01 | 4509486 mumbo_jumbo
mumbo_jumbo's picture

venturen,

yep, just like the republicans did, my best years in business has ALWAYS been with a liberal in the white house, without exception.

Tue, 03/04/2014 - 19:00 | 4509479 mumbo_jumbo
mumbo_jumbo's picture

"such actions are finite"

 

too bad i'll be dead or living in my car when that point is reached.

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