Let’s get something straight – corporate profits are a reflection of the economy, not vice versa. There is also a huge difference between corporate profitability based on top line revenue growth and bottom line cost cutting.
Lately, there have been a plethora of analysts talking about the continuation of the bull market due to the expectation of rising corporate profits to record levels in the coming year. I have one question – how?
Corporations depend on sales to consumers to create revenue. “Sales,” and ultimately the “revenue” generated by the sales effort, are at the very top line of the income statement.
According to S&P here are the last several quarters “revenue” numbers:
That is a decline in revenue in the 1st quarter of 2011 yet profit margins rose. Increases in the amount of net income at the bottom of the income statement can only be achieved by 1) increases of revenue at the top of the income statement; or 2) decreases in the expenses at the bottom of the income statement.
As you can see by the chart revenues have “normally” grown at fairly consistent levels with bottom line earnings prior to the economic recession in 2008-09. Post that recession profit margins have surged due to massive cost cutting, layoffs and benefit reductions – in other words profitability came at the bottom of the income statement. There is nothing wrong with this in the short term, however, it is a method of profit growth that is unsustainable in the longer term and, eventually, either top line revenue grows or profits began to fall. As shown that is exactly what happened in the first quarter of 2011.
There is more to the story. Since the depths of the “Great Recession” the disconnect between sluggish revenue growth and and the explosion of profits is now beginning to subside. The laggard pace of revenue growth is consistent with the very stagnant growth rate of the economy since it is the revenue generated by sales of products or services which are the reflection of the consumer and the economic environment as a whole. Looking back from 1947 to present the annualized changes in earnings per share (EPS) for the S&P 500 and gross domestic product (GDP) have remained fairly constant.
Therefore, if EPS is a reflection of GDP it is highly likely that as the economy continues to remain in a slower growth environment that earnings, and ultimately profits, will also began to become more sluggish. This in turn leads to the concern of the markets generating lower rates of annualized returns for investors as prices adjust to reflect lower profit growth.
With an already weak economy it is only a function of time before the markets began to adjust for lower profit growth. With the year over year profit growth of companies on the verge of going negative; asset prices will have to adjust to meet the decline in profitability. Since companies have already slashed head counts to the bone, cut back on inventories and are staffing with temporary workers; it will be exceedingly difficult in the future to mask declining profits with further cost cutting.
One final thought – Don’t count on an 8% annualized return going forward to plan for your investments. The math tells you otherwise. Since 1947 GDP has grown 6.6% annually, EPS has grown at 6.7% annually and the average growth of the S&P index itself has grown at 6.6% (not including dividends). Going forward if the economy is slated to grow at an annual rate of 4%, as hoped by the current slate of economists and Wall Street analysts, then it is going to be difficult to crank out 8% returns in portfolios for retirees hoping to get away with under saving for their retirement.
However, If the next decade of a debt laden economy burdened by high unemployment, higher rates of inflation and lower wages, then economic growth may be more aligned to grow at a mere 2-3%. If you Include a current dividend yield of 2% plus 2-3% growth in the markets on an annualized basis; it becomes very difficult to navigate through retirement particularly if you were underfunded to began with.
So, when someone yanks out that chart of the S&P 500 going back to 1900 and tells you that investing for the long term works – do the math.