Next time your investments are on a roll and you catch yourself feeling the familiar symptoms of overconfidence, I recommend you check out the Hussman Fund’s market commentary. I’ve found the relentlessly bearish perspective put forward in all of Hussman’s articles to be a sobering antidote to any euphoria I might be feeling at the time. I disagree with some of the reasoning and certainly with the conclusions, but he does raise an issue that piqued my interest and is the subject of this post. Aggregate corporate profit margins are about as high as they’ve ever been. How sustainable is this?
The main reason for Hussman’s bearishness is the idea that, in aggregate, equities are overvalued. Not just a little overvalued, but astoundingly so. Hussman expects US equities to lose close to two-thirds of their value from the peak set in October last year.
This may seem strange if you were to take the most obvious ‘off-the-shelf’ measure of stockmarket valuation, the ratio of total market capitalisation to profits i.e. the aggregate price earnings (PE) ratio. The S&P 500 current trailing PE ratio is about 20, not too far from its long term average of around 16. Of course the simple PE ratio ignores that the stock market and wider economy is cyclical. It is likely to overstate valuations at the bottom of the economic cycle, when earnings are temporarily depressed, and understate them at the top, just before earnings fall. The cyclically-adjusted PE ratio (or CAPE) seeks to address this by measuring 10 year average earnings in the denominator. The CAPE currently suggests that the market is overvalued for the simple reason that earnings have risen a lot over the last 10 years. I have my doubts about how informative the CAPE is, as I described in this post on market crashes. Basically, I believe the economic cycle is likely to be less regular and predictable in the future than the CAPE assumes based on history.
As an aside, I am also not convinced that the long term historical average is a reliable benchmark for whether current valuations are fair. The history of the modern stock market is short and ecompasses a period of significant change in economic policy and the economy itself. Equity valuations appear to have trended upwards over the last 40 years rather than just oscillating around a stable long term average. Market crashes have also become less frequent.
Hussman takes the logic of the CAPE one step further by also ‘normalising’ corporate profit margins to the 10 year average. Corporate profitability has increased fairly dramatically in recent years, so this adjustment makes equities currently look wildly overvalued. According to the ‘margin-adjusted’ measures, equities have only been fairly valued at the nadir of the Financial Crisis. This seems to be a rather extreme and dubious conclusion, but it does highlight some interesting questions. Why have corporate profit margins increased so much over the past 20 years and are we due a painful mean-reversion?
Corporate profit margins have risen
The chart below shows US corporate profits as a share of GDP.
Historically corporate profits have tended to oscillate around 4% to 8% of GDP. However, over the last 20 years there seems to have been a structural shift, where corporate profitability has shot up to around 10% of GDP and has managed to stay there for quite some time.
In the past higher corporate profit margins have tended not to last and have been described (by the investor Jeremy Grantham) as as ‘probably the most mean-reverting series in finance’. As pointed out in this article from 2015, peaks in corporate profitability have tended to precede recessions in the past. However, this conventional wisdom is being challenged at the moment with profit margins stubbornly remaining around historically extreme levels with no recession in sight.
Why has corporate profitability risen?
A lot of the commentary I’ve come across focuses on whether falling costs may have driven recent increased profitability. Interest rates have fallen to historically low levels, reducing the cost of corporate debt. Corporate taxes and labour costs as a percentage of income have also both been falling. Surely these costs will mean-revert, reducing corporate profitability back to its historical average?
Well I wouldn’t assume so. The fall in all of these cost drivers seems more secular than cyclical, likely due to fundamental changes in the structure of the economy, such as ageing demographics and reduced capital intensity. None of them seem likely to mean-revert any time soon. Corporate taxes and the share of labour costs have been declining since the 1950s and interest rates since the 1980s. More importantly, this analysis is incomplete. Profits are a function of both prices and costs. This is where competition comes in. If costs fall, over time so should prices as excess profits should be competed away. This leads to mean-reversion and seems to be what has happened in the past. Has something happened to alter this process?
It has indeed. Competition may still be alive and well but its nature has changed, along with the nature of the businesses that are competing. I suspect it is not a coincidence that corporate profitability has risen along with the advent of the internet. The technology sector has driven a significant portion of the increase in corporate margins. These businesses tend to have capital-light cost structures and the capacity for extremely rapid growth. They also tend to benefit from competitive advantages to a much greater extent than more traditional businesses, due to more differentiated products, switching costs and network effects. In many cases these factors result in very substantial first-mover advantages and allow the winners to sustain high margins for extended periods. Competition in these markets is much more dynamic, as businesses compete to innovate to become the first mover and gain the resulting rewards.
How sustainable is high corporate profitability?
I don’t think there seems much likelihood that profit margins will naturally ‘mean-revert’ of their own accord. The changes in competition I describe above are fairly fundamental in nature and don’t look likely to reverse themselves anytime soon. If anything it’s more likely that corporate profit margins would continue to increase as technology accounts for a greater proportion of the economy.
The more difficult question is whether public policy is going to do anything to bring corporate margins down. Warren Buffett hints at a role for public policy in the following quotation from back in 1999:
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.
This comment did not age particularly well, given corporate profit margins almost doubled pretty soon after it was made and have remained there ever since (barring a short dip in the Financial Crisis). I’ve discussed how competition has changed. While I think Buffet’s point about a possible political constraint on margins has merit, the ‘economic pie’ analogy oversimplifies the economic reality.
The division of rents between businesses, workers and the government is not zero-sum as implied by the pie analogy, nor can it easily be controlled by public policy. Absent price regulation, businesses are always going to take their cut. Higher labour costs or corporate taxation would be passed on by businesses to their customers in the form of higher prices, preserving profit margins. For the most part, we rely on competition to constrain corporate profitability.
Of course, public policy does not need to be toothless. There is the potential to regulate prices or enforce antitrust policy much more aggressively if there is the will to do so. This would require quite a shift from the current approach to these tools, but there is political momentum building behind this idea. There are tricky trade-offs to balance, none more so than the risk that trying to regulate competition more aggressively would harm dynamic competition and the benefits it brings.
As explained in this article, GDP doesn’t account for what is likely the most important slice of the economic pie: consumer surplus i.e. the additional benefit that consumers get for consuming products and services above what they have to pay for them. The consumer share of the pie is almost impossible to measure but appears to have been growing substantially over time. New technologies, particularly the internet, have given us many incredibly valuable innovations, while we have often not needed to pay much for them, in some cases nothing at all. Think about how much benefit there is from near-universal instant access to all the public information in the world through online search. GDP values this at zero as it is provided for free. Pedestrian GDP growth belies the benefits of the accelerating technological progress happening in the real world.
The concern is that public interventions to regulate competition aggressively would have the perverse effect of reducing the ability of competing businesses to come up with new innovations and the associated consumer surplus. This concern could be well-founded. Forcing businesses to all play by the same set of prescriptive rules has often had the perverse effect of harming competition in the past. There is a role for stepping in to deal with monopolies when prospects of dynamic competition are limited, but judging this well is very hard.
Of course, the politics will decide what happens rather than just the economics. However, while it’s certainly not outside the realms of possibility, I am sceptical that there is sufficient will for a radically more interventionist approach. In my view higher corporate profit margins are here to stay.