Friday, June 10, 2011

Corporate Profits vs. Dollar Index

This is a continuation of yesterday's post and is inspired by the comments of Wisdom Seeker and Jazzbumpa.

They felt that I should have used an exponential growth curve. I could not see the driver of such a curve since I was already adjusting for population growth and inflation. It then dawned on me. The exponential part comes from our desire to exponentially devalue our way back to prosperity.

In the charts that follow, I'm using the dollar vs. other major currencies as seen in the "Trade Weighted Exchange Index: Major Currencies" at the St. Louis Fed.




Note that the relationship is on a curve. Here's what happens when I use the inverse of the dollar index instead.



As the value of the dollar relative to other currencies goes down, the real profits per capita go up.

This has huge implications. We can have nearly infinite real corporate profits per capita if we can get the dollar's value relative to other currencies to go to nearly zero. There's just one small problem. Oil will be nearly infinitely expensive.

Here's some bonus sarcasm. If we can get this dollar index down to 1, then this chart shows we will have $588,000 in real annual pre-tax corporate profits per capita. Other than attempt to buy oil with it, what will we do with all of that prosperity?


Update:
Here's another way to look at that second chart.



Source Data:
FRB: Flow of Funds Accounts
St. Louis Fed: Population
St. Louis Fed: CPI-U
St. Louis Fed: Trade Weighted Exchange Index: Major Currencies

19 comments:

Stagflationary Mark said...

As a side note, every country wants to see their currency devalued compared to everyone else's.

So far we seem to be winning that game. What if we start to lose?

Put another way, why do investors continue to think the Euro is such a sure thing?

Can the euro catch up with the falling dollar?

The race to the bottom in currencies could get more competitive.

The dollar has a nice head start, having dropped 16% over the past year against a basket of major U.S. trading partners. But the benefits of a weaker currency – cheaper exports, the ability to stick it to your creditors by repaying them with less valuable paper, abundant opportunity to blame your problems on hapless central bankers – aren't lost on people outside this country.

Mr Slippery said...

As a side note, every country wants to see their currency devalued compared to everyone else's.

You just made the case for gold, at least until the competitive devaluation game is over.

Nice charts.I'm still not clear on why or how a lower dollar relative to other currencies leads to increased "real" profits. Nominal, I get, but real?

Lower wages -> higher profits makes sense.

Stagflationary Mark said...

Mr Slippery,

You just made the case for gold, at least until the competitive devaluation game is over.

I made the case for hoarding something until the competitive devaluation game is over. I grant you that. I don't necessarily think I made the case for gold at these prices though (for reasons I've given elsewhere).

I'm still not clear on why or how a lower dollar relative to other currencies leads to increased "real" profits. Nominal, I get, but real?

I'm still working it through too. Here's one way it could.

A small drop in the value of the US dollar gives an American company a slight export advantage. A slight export advantage can lead to a large real profit increase.

Picture this as an example.

Let's say a US company is running their factory at 70% capacity.

Now picture what happens if it can run that factory at 77% capacity thanks to a falling dollar.

Chances are that real profits will rise more than just 10% (77/70) if only because the factory's fixed real costs will not rise.

Picture a restaurant that is barely keeping afloat and suddenly finds itself with 10% more customers (thanks to a falling dollar making tourism here more attractive). If its real rent stays constant, its real utilities stay constant, and it doesn't need to hire many (if any) more workers to serve its new customers, then the real profits would increase dramatically.

Unfortunately, if the restaurant makes too much money then a new restaurant will pop up right next to it. This would be especially bad if the dollar stopped falling and reversed.

Stagflationary Mark said...

Here's a case I am also making.

Perhaps there are way too many dollar bears. Since when has the market ever rewarded everyone being right?

Dollar Bear Rogers Say He’s Buying Greenback as Others Shun It: Tom Keene

“I actually own the dollar right now,” Rogers said in a radio interview on “Bloomberg Surveillance” with Tom Keene and Ken Prewitt. “I saw that 95 or 96 percent of people are bearish on the dollar, so I stepped in and bought.”

Mr Slippery said...

Chances are that real profits will rise more than just 10% (77/70) if only because the factory's fixed real costs will not rise.

OK, I sort of get that. It works as long as most of their costs are fixed and they don't have to pay higher commodity input prices. The good news for companies now is that labor has no pricing power with >9% UE.

Re: dollar
I am a short term dollar bull right now given the limited options for the PIIGS and the short window in which EU/ECB has to act. Also the public disagreement between the German finance minister and Trichet. Long term, I don't like any currency tied to a country because they are all racing to the bottom. No other choice, really.

I hoarded some chili, vinegar, and extra toothbrushes today and just passed 10,000 nickels. Copper and nickel are both crashing now, but my horizon is 10 years. I just don't want my hoarding to become a diagnosis. :)

getyourselfconnected said...

Great work Mark but I have to admit the scatter plots are beyond my limited noggin to fully grasp.

Stagflationary Mark said...

Mr Slippery,

I just don't want my hoarding to become a diagnosis. :)

Hahaha! I think you will only get an unfavorable diagnosis if you are caught hoarding items that have been proven to go down in value over time. For example, cottage cheese is generally not considered to be a good long-term store of value. ;)

Stagflationary Mark said...

GYSC,

I'll add another chart so that everyone can more easily see the relationship.

Stagflationary Mark said...

Mr Slippery,

It works as long as most of their costs are fixed and they don't have to pay higher commodity input prices.

I've been giving that more thought and I would reword it slightly.

It works as long as the benefits of fixed real costs outweighs the penalty of rising real commodity input prices.

Eventually the penalty can overwhelm the benefit and that is exactly why I offered the following in my original post.

Here's some bonus sarcasm. If we can get this dollar index down to 1, then this chart shows we will have $588,000 in real annual pre-tax corporate profits per capita. Other than attempt to buy oil with it, what will we do with all of that prosperity?

Nobody in their right mind could possibly think that we would have $588,000 in real annual pre-tax corporate profits per capita if we managed to get the dollar index down to 1. Something seriously breaks long before that point.

getyourselfconnected said...

Thanks Mark! Not the picture I was expecting, a little confused. Will review tomorrow.

Stagflationary Mark said...

GYSC,

The profits are in black and are on the left scale.

The inverse of the dollar index is in red and is on the right scale.

Here's probably the most confusing part. Why am I using the inverse of the dollar index and not just the dollar index itself?

It's because of the shape of that first graph. The data was curved and that shape reminded me of a 1/x graph. In this case "x" is the dollar index.

As the dollar index approaches infinity the real corporate profits approach zero (just as 1/x would).

As the dollar index approaches zero, the real corporate profits approach infinity (just as 1/x would).

I can't say that it is a perfect match but it does seem pretty close.

That said, it is a very simple model intended to represent a very complex thing. I can't prove that it is even a good model nor do I intend to show that even if the model is good that it will continue to work into the future.

At best, it is mostly intended to show how we got to where we are now. Maybe.

Jazzbumpa said...

I guess a simple explanation is that a weaker currency leads to a competitive advantage in world markets. How that comes into play when big corps are multi-national is a bit more problematic, perhaps.

Other than that, I really don't know what to make of it.

Also, I'm not convinced a straight line is valid. Throwing a straight line over a scatter plot creates an illusion of validity (what made me think to say it THAT way?)

The long, narrow flat from DI = 110 to 150 in the first graph might be particularly meaningful. Also, it looks like there is a lot more data scatter, and a big curve up below DI = 90.

Are you up for determining Std Dev and Relative Std Dev?

I love the snark, but still feel obligated to caution about extrapolations.

I wonder if the data set is reality-bounded by about 70 to 150. Points tend to cluster in the 90 to 110 range.

Interesting piece of work. You do have original ideas and a unique perspective.

Cheers!
JzB

Stagflationary Mark said...

Jazzbumpa,

Also, I'm not convinced a straight line is valid.

I can't argue with you. I consider trend lines to be artistic opinions at best. This is why I offer a trend line disclaimer.

I love the snark, but still feel obligated to caution about extrapolations.

We are in 100% agreement here as is seen in the comment I left just before you posted this.

...nor do I intend to show that even if the model is good that it will continue to work into the future.

There's nothing more dangerous than extrapolating an existing trend into the future and thinking that it is a "sure thing". I would once again offer this chart as proof. 61 years of nearly perfect trend history did not hold up so well in the following 11 years. Let's just put it that way.

I wonder if the data set is reality-bounded...

I think it very much is. That's why I don't believe that we can devalue our way back to prosperity.

Stagflationary Mark said...

I meant to add that the correlation on that scatter plot was rather high. I didn't post it though. Here it is.

R-squared = 0.5315

Stagflationary Mark said...

I placed a linear trend line on the first chart and the r-squared value was a lower 0.4696.

The eyeball didn't exactly like the look of it. The data points were too high on both the left and right sides of the chart. The data definitely appears curved to me.

That's not to say that it is curved though. I could be wrong to think this way. Once again, this is a subjective opinion.

Wisdom Seeker said...

Mark, this is truly awesome stuff! I got goose bumps when I saw that plot - totally was not expecting so much correlation.

Honestly, I thought if you put it on a log scale, that would better compensate for (a) productivity growth and (b) failure of the CPI to accurately measure inflation. But what you've got is truly a stunning correlation.

By way of interpretation, I offer two parallel explanations, neither of which is mainstream but both of which deserve further looks IMNSHO:

(1) In terms of profitability of overseas operations of U.S. corporations: thanks to tax dodges, corporations are loathe to repatriate overseas earnings properly. A company which wants to hide overseas profits from the tax man (but not its Wall Street owners!) often shuffles parts around at odd prices in order to generate the "profit" overseas and run neutral or at a loss domestically, right? This causes U.S. exports to be recorded below an honest market price (to show less revenue) and imports to be recorded above price (to show greater costs). The result is potentially a huge contributor to the U.S. trade deficit. Said deficit implies a massive export of dollars instead of goods, which in turn drives the dollar index down (all other things being equal).

(2) Alternatively, in terms of indebtedness: Suppose we temporarily think of the value of the dollar literally as the value of the "Federal Reserve Note" - a very special class of debt with zero maturity. As the amount of debt grows, the value of said debt has to be less (relative to actual economic outputs i.e. goods and services), because there's only so much economic output to be shared among the workers and debtholders. Unless actual production is growing, an increase in claims against that production implies a decrease in the value of each claim. So perhaps we can think of the dollar index reflecting the immediate value of U.S. debt. During periods when there is a large debt overhang, or when interest rates are unusually high, there are larger than average interest streams, and generally these flow from consumers to businesses (thinking in terms of mortgages, but also in terms of taxpayer tax dollars flowing to Treasury bondholders e.g. pensions and banks)? So corporate profits might rise when more people than usual have been persuaded to part with interest payments?

Wisdom Seeker said...

One more thought - if you normalize not in terms of corporate profits per capita, but corporate profits per worker (using the Fed's total employment data), what does that look like? The number of workers as a proportion of the population was climbing from the 50's to the early 00's, it could be that some of the growth in corporate profitability came from having more workers to reap profits from?

I think you should circulate this whole issue more widely if you can, once you've mined it out from here, to see what other explanations there may be!

If the economic cure for the U.S. is to haul corporate profits back down to earth (and by extension to increase the share of national income going to wages and salaries, which I think is what is needed), your data strongly implies that we genuinely need a stronger dollar. And that has HUGE policy implications!!!!

I don't know how to get this into the brains of any respected economists, though, but we should...

Stagflationary Mark said...

Widsom Seeker,

I think your two parallel explanations have merit.

I also think that we need to get profits into the hands of the workers (one way or another).

You are going to find the profits per worker chart more than fascinating. I'll be posting it shortly as its own post.

Stagflationary Mark said...

Wisdom Seeker,

The number of workers as a proportion of the population was climbing from the 50's to the early 00's, it could be that some of the growth in corporate profitability came from having more workers to reap profits from?

Based on my latest post, I would argue that ALL sustainable profits came from that. I think you will be more comfortable with my flat median line this time.