Wednesday, June 12, 2013

Is the profit share a trending variable now?

Gavyn Davies writes a piece on corporate profits and the equity market. He observes that some investors are concerned that "the profit share in the U.S. economy is currently abnormally high." Because investors assume that the profit share mean reverts, he explains, sooner or later corporate earnings and profit margins will decline, and equities will tumble. But then Davies goes on to undermine this assumption, and ventures that the profit share might not mean revert at all "in the foreseeable future."

The following chart shows the ratio of a national accounting measure of profits (corporate profits after tax with inventory valuation adjustment and capital consumption adjustment) to nominal GDP. The share of income that goes to corporations (the profit share) lacked a clear trend until the early 1990s. The profit share appeared to hover around a long-term median of 5%-6%, with large cyclical fluctuations. Then each subsequent cyclical peak of the profit share (late 1990s, mid- to late-2000s, and 2012-2013) got higher and higher, and there appears to be an underlying, long-term rising trend in the profit share. The question of whether we are witnessing a rising trend profit share is of the utmost importance, and not only for the valuation of equities. But framing the question, as Davies does, as an "either/or" proposition, I think, obscures  projections for the medium term.

I am willing to accept some arguments for a rising trend of the profit margin. Globalization and the decline of unions are two of them. But that is still compatible with the view, which I subscribe, that the profit share exhibits cyclical fluctuations. The only thing that may have changed since the early 1990s is that, instead of fluctuating around a fixed number, say 5%, now the profit exhibits cyclical fluctuations around a rising trend. There is tremendous uncertainty about what this trend level might be right now, or even about whether this trend exists at all, but if we are still on the same long-term trend that started in the early 1990s, the trend value of the profit share might be now between 7.5% and 9%, based on a simple linear extrapolation. That means that the profit share right now is between 0.5 and 2 percentage points above trend.

Data on corporate earnings going back to the 1870s [xls] seems to suggest that earnings do revert. In most cycles, earnings peak at a median 2 months before the onset of recession, and bottom out during recessions. If you think that this time the cyclical behavior of profits is going to be different, I would like to know why.

If Davis, on the other hand, is referring to the effect of a rising trend profit share on market valuations, while allowing for (potentially deep) cyclical fluctuations, then I agree with him. Still, I think we need to understand more about what is driving this trend before we make long-term projections.

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