how to think about the high profits relative to GDP

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how to think about the high profits relative to GDP

Postby larryswedroe » Fri Apr 05, 2013 12:16 pm

http://www.cbsnews.com/8301-505123_162-57577547/are-companies-high-profits-bad-for-stocks/

Been getting lots of questions about this one so thought should write up a piece on it.

Hope you find it helpful

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Re: how to think about the high profits relative to GNP

Postby garlandwhizzer » Fri Apr 05, 2013 12:35 pm

Excellent and thoughtful post, Larry.

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Re: how to think about the high profits relative to GNP

Postby richard » Fri Apr 05, 2013 12:51 pm

The bottom line is that if you believe markets are efficient or you believe they are not efficient but you are not able to outdo the markets, then sit back, relax and don't think about changing your investments.

For those interested, here's corporate profits (CP) as a percentage of GDP:
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Re: how to think about the high profits relative to GNP

Postby patriciamgr2 » Fri Apr 05, 2013 1:14 pm

Larry: thank you for posting this article! With reference to the use of Shiller's CAPE ratios, I was curious as to the level at which you would become concerned. My understanding is that the average is about 15; currently, we're at about 23 (which is nowhere near the high of about 46 in March 2000). Because I switch from lump-sum adding to dollar averaging in new money whenever the market seems "overvalued", this information is of interest to me.

Thanks for any input you can offer. regards, patricia
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Re: how to think about the high profits relative to GNP

Postby larryswedroe » Fri Apr 05, 2013 4:28 pm

patricia
First the average is about 16 going back to 1880s but IMO that is not good benchmark because the world has changed greatly since then in terms of costs of investing in stocks and ability to diversify and so on. So IMO it makes sense to think the ERP has come down, justifying higher valuations. Since 1950 the average I believe is about 20, so we are much closer to that. Personally I think it's more important to look at current metrics and also not to look at market PE but the assets you invest in

So for example while I became concerned about the market in 1998 as valuations went above 25 P/E and that led to my changing my portfolio to all value because value stock valuations were about normal. That led to much worse performance for two years and then much better performance since. For Shiller P/E you might look at my article on the CAPE 10 and the data presented. above 25 seems to be a good historical indicator of trouble, and the higher the more trouble. But you need to also look at current valuations IMO.
[url]
http://www.cbsnews.com/8301-505123_162- ... e-brewing/[/url]

If you get current P/Es around 20 or higher is when I would start to be more worried, but you almost cannot get there with value stocks, which is another reason I prefer them, By definition they are the most distressed stocks with the highest expected returns (whether you believe in the risk story or not that is true)


And remember the more you tilt the less stock risk you need and that has historically cut the tails
Best wishes

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Re: how to think about the high profits relative to GNP

Postby patriciamgr2 » Fri Apr 05, 2013 4:30 pm

Fabulous input, Larry! Thanks so much for taking the time from your schedule. much appreciated by many of us on the Forum. Cheers, Patricia
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Re: how to think about the high profits relative to GNP

Postby Sidney » Fri Apr 05, 2013 4:34 pm

Is there a comparable view of non-US equity ?
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Re: how to think about the high profits relative to GNP

Postby larryswedroe » Fri Apr 05, 2013 6:19 pm

Sidney-you can just look at value metrics of similar Vanguard funds and you'll find international stocks LOT cheaper,, now of course that reflects higher risk perception--and also in term higher expected returns
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Re: how to think about the high profits relative to GNP

Postby Rick Ferri » Fri Apr 05, 2013 6:30 pm

Larry,

Shouldn't that be GDP?

Anyway, remember this post from more than a year ago?

Hussman: Now is one of the worst times in history to invest!

So much for what Hussman thinks.

I believe people are missing a key element. Financing costs are almost 0% for corporations. It's never been this low. How does that change the equation? It adds a lot of financial leverage to an organization and that's what's leading to higher profit earnings.

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Re: how to think about the high profits relative to GNP

Postby larryswedroe » Fri Apr 05, 2013 6:53 pm

Rick
Yes though it doesn't matter much
Just rushing in writing and that can cause sloppiness--just too much to do (:-))
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Re: how to think about the high profits relative to GDP

Postby LadyGeek » Fri Apr 05, 2013 7:11 pm

^^^ I got it. :wink:

If the profits increase, wouldn't the company use the profits to further their business? That would increase their expenses and the profits would drop. To me, corporate growth would be a source of reversion to the mean. Perhaps my view is over-simplistic and I'm missing a basic point here.
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Re: how to think about the high profits relative to GDP

Postby Nathan Drake » Fri Apr 05, 2013 7:29 pm

Are they taking US corporate profits and comparing them to US GDP?

If so, that's not a very good comparison given that the share of US companies business overseas is growing.
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Re: how to think about the high profits relative to GNP

Postby Bradley » Fri Apr 05, 2013 8:33 pm

larryswedroe wrote:-just too much to do (:-))
Larry


9413 posts and counting :wink:
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Re: how to think about the high profits relative to GDP

Postby Jeff Albertson » Sat Apr 06, 2013 9:51 pm

Larry, thanks for the informative article. It provides a lot to think about.

You are probably aware of the 1999 Fortune article by Carol Loomis where Buffett says:

You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems--and in my view a major reslicing of the pie just isn't going to happen.


Buffett's 2013 letter (that you quote) seems to somewhat temper the above.

Buffett (as well as the ones you mentioned, Grantham and Hussman) tend to think there will be a reversion back to 6%. I'm not so sure.

This week's podcast of Peter Day's World of Business (BBC Radio 4) is related, & is about the productivity paradox. He interviews MIT's Erik Brynjolfsson and Andrew McAfee about their ebook "Race Against The Machine" (aka The Robot Took My Job). They discuss some issues related to your article. More & more sophisticated professions are being automated, with both good and potentially bad consequences.
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Re: how to think about the high profits relative to GDP

Postby larryswedroe » Sun Apr 07, 2013 8:55 am

Jeff

Yes it is obvious that profits as percent of GDP cannot grow forever. And high margins reflect corporate leverage over workers in terms of wages and eventually that reverts and vice versa. The question is when or even if it must revert. In addition, as I note you can have RTM of profits relative to GDP but that doesn't mean profits must fall, nor stock prices rise. If this was simple where are all the active managers who timed this information successfully?
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Re: how to think about the high profits relative to GDP

Postby Rick Ferri » Sun Apr 07, 2013 10:25 am

Given the persistent decrease in the labor participation rate in this country, it seems to me that the supply of potential labor would keep wage growth low. Any increase in real wages would draw more people into the workforce and offset real wage increases. So, I don't think wages will cause the regression to the mean.

I already mentioned that increased interest rates would be a major factor in the regression, but something else may be a slowdown in productivity that result from some unknown variable (I say it's unknown because its unknown to me - others might know the reason). On the other hand, if corporate tax rates are cut as it has been proposed by both sides of the aisle there would be a boast to profits.

Remember the good ole Dupont formula. Net profit margins are a result of three types of leverage in a corporation; financial, operational, and taxes. Better financial leverage comes from low cost of capital, which we already have with rock bottom interest rates. Operating leverage comes from productivity gains. We're getting better productivity from stable wages, stable prices, fewer workers and better technology. The final leverage is taxes. Corporate rates have been the same for quite some time so this hasn't been a factor. If rates go down, profits go up, and that increases profits as a percentage of GDP.

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Re: how to think about the high profits relative to GDP

Postby Valuethinker » Sun Apr 07, 2013 1:48 pm

LadyGeek wrote:^^^ I got it. :wink:

If the profits increase, wouldn't the company use the profits to further their business? That would increase their expenses and the profits would drop. To me, corporate growth would be a source of reversion to the mean. Perhaps my view is over-simplistic and I'm missing a basic point here.


The theory is that as profits increase you attract more capital chasing those higher returns. More investment, which leads to more competition and more productive capacity, and so margins and returns are driven back down.

That theory is as old as Karl Marx, maybe older. In Marx's view it is what leads to the inherent instability of capitalism (there's a lot more to his theories than that) and boom and bust.

However it's not clear there is such a thing as a 'normal' in returns on capital/ profit margins and therefore that we can speak of 'reversion towards the mean'.

Globalization and changing technology undoubtedly have a big impact on corporate profitability. The American (or European) worker now is effectively competing with a factory in China and a call centre or software development centre in India. *that* restrains wage growth, and may increase corporate profits.

It's what corporations do with profits, to:

- they could invest them in expanding operations (leads to the situation Marx described)
- invest them in buying other companies (good for shareholders of the targets, not so much the acquirers)
- buyback shares and pay dividends - good for shareholders

You won't get a shift back towards workers unless the unemployment rate drops significantly, say with changing demographics. Someone turning aged 10 now is probably going to be in fairly good shape (pace globalization and technology).

The most important decision you make about your career, other than your choice of high school and university major (and trivially what country you were born into), is the year you chose to be born. That's a fairly strong and consistent result in the research. In the classic study, Stanford MBAs in the investment banking industry (very cyclical) join in a particular year. What year you joined i banking has an impact on your earnings *20 years later*.
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Re: how to think about the high profits relative to GDP

Postby grayfox » Sun Apr 07, 2013 2:11 pm

I recall watching a history documentary about the middle ages. When the black death came and wiped out a huge percent of the European population, there were not enough peasants to do the work. The peasants were able to demand a bigger share of the pie, and the lot of peasants in Europe vastly improved.

There are silver linings, even with something like the black plague.

If a worldwide epidemic kills off much of the world population, instead of the glut of labor we have now, there would be a labor shortage, labor will be in a stronger bargaining position. A greater share of output will have go to labor, and a lesser share to owner's of capital. Profit margins would come down.

That is probably why Bill Gates is trying to eradicate diseases around the world. Labor activists should probably be working on developing new and more resistant strains.
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