How Long Can Profits Continue to Outpace Sales, Productivity, and GDP Growth?

By the Curmudgeon with Victor Sperandeo

Introduction:

After-tax corporate profits rose to $1.9 trillion in the 4th Quarter of 2013, the BEA/Commerce Department reported on March 27th. That was up 4.8% from a year before and up much more than GDP. Profits after tax, with inventory valuation and capital consumption adjustments, increased $108.5 billion, compared with an increase of $71.2 billion in the prior quarter.

The latest uptick in profits underscores a factor that has bedeviled the economy since it emerged from recession (or are we really still in recession?): Corporations are guarding their cash rather than putting it back into the real economy in the form of new hiring or capital spending. For many years now, companies have been slow to hire and slow to raise wages.

"Companies are continuing to squeeze productivity gains out of existing workforces," said Dan North, chief economist at credit insurer Euler Hermes Americas. Many businesses continue to keep a tight grip on spending amid uncertainty about the economic outlook at home and abroad, he added.

Indeed, inflation has outpaced gains in private-sector employee compensation over the past five years, according to the Labor Department. Spending on new equipment has been muted, too. Aggregate capital expenditure for members of the broad S&P 1500 index has grown by just 0.8% annually over the past five years, according to S&P Capital IQ.

What we find particularly egregious (which no one else has picked up on) is this sentence: "Taxes on corporate income decreased $15.9 billion in 2013, in contrast to an increase of $60.6 billion in 2012." Income statements from S&P 500 companies showed an effective tax rate, including state and local taxes, of 29% in 2012 versus 32% in 2007, according to ISI Group's David Zion. He calculates their cash tax rate—what they actually paid—was 25% in 2012, against 31% in 2007.

That fact begs this question: Why are tax rates decreasing for corporations yet rising for individuals? Why are so many people hit with the AMT which disallows deductions for state taxes and investment expenses at the same time as corporate tax rates have fallen?

Another very important item is that corporate profit as a percentage of gross domestic product (GDP) hit yet ANOTHER all-time high at 11.1%. That's up a bit from the prior quarter, but a staggering increase from 4.6% in the 3rd Quarter of 2008. If the measure was back at the average of 5.4% that prevailed in the 1990s, profits would be half what they are now.

Check out the eye opening chart below:

Corporate Profits After Tax (without IVA and CCAdj)/Gross Domestic Product

Low interest rates have also improved the bottom line. They have allowed many companies to refinance debt, cutting their interest costs. The effective yield on investment-grade corporate debt, according to the BofA Merrill Lynch Corporate Master index, is now 3.1%, versus 5.8% in December 2007.

Analysts expect margins to keep expanding, estimating that profits for S&P 500 companies will grow by 7.4% this year even as sales expand by just 3.8%, according to S&P Capital IQ.

Curmudgeon asks: How long can profits continue to outpace sales, productivity, and GDP growth?

Justin Lahart of the Wall Street Journal (on line subscription required) doesn't think the rising profit trend will continue much longer. In particular, if corporate profits continue to grow faster than the real economy, it might signal trouble ahead. In the March 28th WSJ, Mr. Lahart wrote:

"Keeping costs low by refraining from hiring or not replacing equipment can only be done for so long, though. And long-term interest rates look more likely to rise than fall over the next year. Losses to offset taxes, too, eventually get used up.

But the desire to show high profit margins will endure. Barring an unforeseen surge in economic growth, meeting Wall Street's piqued expectations will tempt companies to continue underinvesting. Ultimately, that leads to deteriorating sales—making it even harder to preserve profits."

A Bearish View on Profits from Societe Generale bank (SOGEN):

SOGEN analyst Albert Edwards has been skeptical of the U.S. profit rise for some time. In his latest report to clients (March 27, 2014) he wrote:

"U.S. profits have begun to decline on a MSCI trailing basis – one of the key measures we monitor. We have long believed that the profits cycle is probably the most important leading indicator for the economic cycle, as profits drive the highly volatile business investment component of GDP. The consensus believes that the U.S. has just begun a long economic recovery, whereas we believe it is already quite advanced and vulnerable to events in Asia.

Falling US MSCI profits are an extremely important straw in the wind that investors will ignore at their peril. We have long believed that economists should monitor the profits cycle as closely as equity strategists. Unfortunately, most economic models tend to have profits dropping out as a residual rather than at their heart. Over the years we have found that profits are probably the single most important leading indicator of recession. A decline in profits is inevitably followed by recession shortly thereafter as investment, the most volatile of all GDP components, is cut."

Mr. Edwards strongly believes that it is the rate of growth of profits that should be closely monitored, as it drives the corporate investment cycle.

Andrew Lapthorne published an update (for SOGEN clients) on the U.S. profits situation in the wake of the Q4 reporting season. He wrote: “"At first look, growth in U.S. net income last year looks remarkably good. With nearly all S&P 500 names having reported year-end figures, net income grew 14% last year, or 12.8% on an ex-financial basis. This is fairly impressive growth given the lackluster economic backdrop. So should we be celebrating? Well we're not so sure, as the source of this growth is not a robust improvement in operating cash flow, but is to be found in the large goodwill write-downs of 2012."

Mr. Lapthorne then shows that the vast majority of this 14% growth in profits was driven by company-specific write-downs made in 2012, with Hewlett Packard, AT&T and Verizon Communications leading the way.

Andrew wrote: "Having updated our models to include the latest U.S. report and account income data we find that the key driver of profits growth in 2013 was not a healthy improvement in operating earnings but a function of major 2012 write-downs disappearing from the 2013 numbers. A top 10 list of those companies showing the biggest dollar uplift in earnings was dominated by companies such as Hewlett Packard, which were heavily affected by 2012 write-downs."

According to Mr. Edwards, "Analysts spend far more time downgrading EPS forecasts than upgrading, as they typically start the year with ridiculously overly optimistic EPS forecasts. And when upgrades fall below 40% (or conversely downgrades rise above 60%) it is usually an indication that the economy is struggling. The current pace of EPS upgrades has again dropped below the critical 40% mark that we have long associated with recessionary conditions. What is more worrying than on previous occasions when optimism has dangled below the 40% mark over the last three years is that this time actual MSCI profits are also falling on a year-over-year basis."

Edwards observes that the equity market seems to respond to changes in analyst EPS optimism, which is now declining as seen in the chart below:

Edwards concludes by stating:

"This (economic) cycle is already long in the tooth at 56 months and the resultant slowing productivity growth is beginning to impact profits adversely. While profits growth is so anemic, any adverse shock, such as an Asian currency devaluation (including both Japan and China), will be enough to deepen that profits recession and send U.S. investment expenditure into decline. While most equity investors appear to believe that the US economy has reached escape velocity, a recession carries a far higher risk than the market supposes."

Victor's Closing Comments:

The concept of predicting the financial future is most difficult today, as the markets are virtually all influenced or manipulated. Obnoxious and blatant "Central Planning" has replaced "relatively” free markets. The monetary policies of the Bernanke led Fed are not only unprecedented, but unimaginable in the prolonged period of time they have been in effect. The Fed has kept interest rates in repression for 5.25 years headed for 6.5 years now. When I began trading in 1968, I could not have possibly dreamed of the audacity of the FOMC circa 2008 to the present time.

Have you noticed that no one has a complaint with the Fed's QE and ZIRP? That's because it benefits all those with money, influence, and power. Thereby, the issue and question of corporate earnings is one of "risk and reward." It's not at all about trying to be a soothsayer of market tops or the end of artificially propped up earnings increases.

Global central banks are acting in their own interests - to cover up the lack of fiscal policy and allow the politicians ideology (a move towards socialism) to be sustained. That is not at all good for "the people," but it's obsessively driven by those in power.

As long as the Fed has a "printing press" and the U.S. dollar remains the world's reserve currency, they can paper over (literally) the harm done by political controls and unworkable ideologies, e.g. the ACA.

The current trailing P/E is 19.5 for the S&P 500, which is historically high. Let’s assume the economy is weak (without the weather as an excuse) and starts to falter. The equity markets would also decline, which would put a kink in the "wealth effect" policy that the Fed espouses (despite no evident "trickle down" effect).

All Fed Chairwoman Yellen would have to do is stop the taper and problem solved! The only way the economy and markets are going to go their own way is when the Fed can't "solve the problem with a printing press."

The bottom line is that the actual economic fundamentals can only play out (without manipulation and interference) when the Fed's "paper bullets" don't work. That might be as a consequence of an uncontrollable event (like war), being at the mercy of a rogue world leader, or due to a major policy blunder (refer to the Smoot Hawley bill under then President Herbert Hoover).

The fact that U.S. corporate earnings have increased is not under dispute. But in this case, the rise in earnings came from the Fed's "paper policies," not real demand and production, i.e. real economic growth.

Addendum (by Victor Sperandeo):

Quotes by two former Congressman may be of interest to readers at this time....

1. Upon the signing of the Federal Reserve Act in 1913:

“The new law will create inflation whenever the trusts (the owners of The Fed) want inflation. It may not do so immediately, but the trusts want a period of inflation, because all the stocks they hold have gone down... Now, if the trusts can get another period of inflation, they figure they can unload the stocks on the people at high prices during the excitement and then bring on a panic and buy them back at low prices.…The people may not know it immediately, but the day of reckoning is only a few years removed.”

Congressman Charles A. Lindbergh, referring to the Federal Reserve act, Congressman Lindbergh stated this a few years prior to the stock market crash in 1929 which ushered in the Great Depression Congressional Record, Vol. 51, p. 1446. December 22, 1913).

2. Remarks in Congress: on the Federal Reserve Corporation in 1934:

"We have, in this country, one of the most corrupt institutions the world has ever known. I refer to the Federal Reserve Board. This evil institution has impoverished the people of the United States and has practically bankrupted our government. It has done this through the corrupt practices of the moneyed vultures who control it."

— Congressman Louis T. McFadden (Rep. PA) in 1932.

Does any of the above "ring a bell" today? You be the judge!

Till next time........................

The Curmudgeon
ajwdct@sbumail.com

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1979) to profit in the ever changing and arcane world of markets, economies and government policies. As President and CEO of Alpha Financial Technologies LLC, Sperandeo overseas the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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