Friday, March 13, 2009

Corporate Profits Revisited

Here's something I posted back in 2007. I consider it to be one of my most important charts. This one really gave me an epiphany. Perhaps it will do the same for you.

December 7, 2007

Corporate Profits

This chart shows the total domestic financial, farm, and non-financial corporation profits (before taxes) divided by the total compensation of employees.

How long will it be before we return to the red trend line? Or is this a new permanent era of prosperity? Note that the long-term trend is down. I believe I can offer a simple explanation for that. I would think that in a capitalistic society, competition would eventually squeeze the life out of all profits.

If money can be made, someone will figure out a way to extract it. If a lot of money can be made (like right now it seems), MANY people will find MANY different ways to extract it. You know, just like homebuilders in California once were. Build them fast and sell them even faster!

I excluded the profits made off the "rest of the world" primarily because I'm interested in how our domestic economy is doing. Right now it is doing absolutely fantastic. Just look at all those fat profits ripe for the picking. You'll excuse me if I wait until the bottom falls out first though. I'm no thrill seeker these days.

Here's an updated chart using the most recent Flow of Funds data.

I offer three observations for stock market investors. Keep in mind they are just my opinions though.

1. As predicted, we are clearly heading back down towards the red trend line. There really was no other choice. As seen above, that's the way capitalism must work. Fat profits that are that ripe for the picking will be picked repeatedly until they are gone (one way or another).

2. The red trend line is down. That's actually something that Karl Marx predicted. He claimed that capitalism would eventually squeeze all profits to the vanishing point. In 2007, I was just trying to make sense of the chart. I didn't realize at the time I was actually backing his theory.

3. The line represents the average trend. By definition, we must spend as much time below an average as we spend above an average. That would imply that there's a decent chance we won't conveniently stop once we hit the line. It is not outside the realm of possibility that we drop to 7.5% on the chart. We've done it before. We're at 13.6% right now. That's a long ways down. It is also not outside the possibility that we drop even further than that. First, the trend is down. Second, the bigger the climb the bigger the fall. As seen in the chart, it was a very big climb. We certainly spent a lot of time well above the average.

Any one of those points would scare me away from the stock market, even at these supposedly bargain basement prices. The combination is brutal though. I just don't need the risk. The sidelines have been treating me very well and I'm quite content to stay here. I certainly have no desire whatsoever to bottom feed ABOVE the trend line.

Note that I haven't even mentioned debt yet. That's what originally turned me bearish. I thought we were trying to borrow our recovery. I think you can see how well that worked out by simply looking at the chart from 2004 to 2008. It felt good to borrow the money and then it didn't feel so good. Big shocker.

Are we better off than we were in 2004? I would argue that we are worse off. Most of that debt we threw at the problem back then is still with us. Meanwhile, our stock market is much lower and our unemployment is much higher.

Using debt to solve our structural problems didn't work long-term the last time we tried it so of course we're going to try borrowing again in a much bigger way. That pretty much goes without saying.

Insanity: doing the same thing over and over again and expecting different results. - Albert Einstein

See Also:
Trend Line Disclaimer

Source Data:
FRB: Flow of Funds Accounts


mab said...


Awesome post. The profits/wages ratio is a novel way of looking things.

Does this mean you are questioning Jeremy Seigel's "stocks for the long run" thesis?

Anonymous said...

What do profit-wage ratios have to do with the stock market level?

Stagflationary Mark said...


Does this mean you are questioning Jeremy Seigel's "stocks for the long run" thesis?

I think I'm questioning it just like Japan should have questioned it. I wish I had proof instead of questions though!

Stagflationary Mark said...


What do profit-wage ratios have to do with the stock market level?

When profits relative to wages are high, the stock market is in danger of those profits coming back down.

When profits relative to wages are low, the stock market is in good shape as those profits may come back up.

As a patient long-term investor, I'd prefer to buy stocks when we're nearer to a trough (below the red line). I'd prefer to sell stocks when we're nearer to a peak (above the red line).

You can see it in the chart. Let's look at the peaks and troughs in the past few decades.

Investing in the stock market during the peak of 1979 was relatively dangerous.

Investing in the stock market during the trough of 1982 was relatively safe.

Investing in the stock market during the peak of 1998 was relatively dangerous.

Investing in the stock market during the trough of 2002 was relatively safe (at least in the short-term).

Investing in the stock during the peak of 2006 was relatively dangerous.

It does not appear that we're back in the trough yet. Therefore I would argue that investing in the stock market may not yet be relatively safe (even after its selloff). I would say that investing in the stock market is safer than it was at the stock market's peak though. Maybe it is even close to fair value right now.

I'm not a risk taker though. I only want bargains and at this point in my life I only want serious bargains. I'm willing to miss many decent opportunities for one really good one. It may never come and if so, so be it.

You might ask why I used wages. I wanted inflation adjusted profits so that I could compare what's happening now with historical trends.

I could have used the consumer price index to adjust profits. That would show a relatively low level of inflation. I could have used the growth in the money supply. That would have shown a relatively high level of inflation.

I chose wages because they are reasonably objective and relatively free of controversy. People are paid what they are paid.

And lastly, I don't consider myself all that wealthy but...

And if no outstanding values are available, the wealthy investors waits. He can afford to wait. He has money coming in daily, weekly, monthly. The wealthy investor knows what he is looking for, and he doesn't mind waiting months or even years for his next investment (they call that patience).

But what about the little guy? This fellow always feels pressured to "make money." And in return he's always pressuring the market to "do something" for him. But sadly, the market isn't interested. When the little guy isn't buying stocks offering 1% or 2% yields, he's off to Las Vegas or Atlantic City trying to beat the house at roulette. Or he's spending 20 bucks a week on lottery tickets, or he's "investing" in some crackpot scheme that his neighbor told him about (in strictest confidence, of course).
- Richard Russell

Stagflationary Mark said...


One more thought. As bearish as the market has been, I don't think it has priced in the possibility of much further profit erosion from here. This seems more like a rally based on hope that we've bottomed.

More money was lost during the Great Depression attempting to bottom fish than was lost during the intial crash.

I think the reason is that the P/E (price / earnings) starts looking really cheap to people, right up until the "E" starts falling apart. We've certainly seen that over the past year.

Let's assume for a moment that we've lived well beyond our means and that we have created far more restaurants than the economy could support long-term.

For a while, the government can prop things up. That can't solve the problem long-term though if there really are too many restaurants.

If there are indeed too many restaurants then the restaurant profits will fall long-term and there's not a thing the government can do about it. It could try bailing out each individual restaurant of course. I would argue that even that won't work. I can't even begin to imagine how scared consumers would be in that environment. Each additional bailout scares us more these days, and rightly so (because we will all eventually pay for it in one form or another). Scared consumers do not eat out, if I am any indicator.