Stock prices have been held back for at least the last two years, as the continued turbulence in the euro-zone – alongside the stop/go nature of America’s recovery from the ‘Great Recession’ – has weighed heavily on investor sentiment.
The bulls argue that the incessant focus on the well-known macroeconomic travails in both Europe and the US has seen investors ignore the stellar improvement in the corporate sector’s fundamentals since the profits cycle reached its nadir more than three years ago; the positive spin contends that the virtual sideways movement in the major stock market averages since the spring of 2010 has pushed equity valuations to the most attractive levels in more than a generation. Is the optimism justified?
It is beyond dispute that the corporate sector’s recovery from the ‘Great Recession’ has been nothing short of impressive. After-tax corporate profits, as reported by the Bureau of Economic Analysis, dropped by more than a third between the autumn of 2006 and the winter of 2008 – the steepest decline since quarterly data was first collected in 1947, and almost double the average of the previous ten contractions.
Record earnings seemed a long way off as stock prices plummeted towards their crisis lows during the spring of 2009, but somewhat surprisingly to say the least, corporate profits recovered their pre-recession peak by the end of the very same year. The robust uptrend was sustained in subsequent quarters, and return on net worth reached the highest level since the late-1990s in recent times, while the corporate sector captured a record share of GDP.
The bulls’ frustration with the stock market’s refusal to move higher seems justified in light of the headline numbers concerning trends in corporate profitability. However, a more probing analysis demonstrates that there are valid reasons behind investors’ unwillingness to attach a higher multiple to current earnings.
S&P earnings data reveals that cost-containment and the accompanying margin improvement accounts for almost three-quarters of the cumulative increase in per-share profits over the last three years, with top-line growth accounting for the remainder. The relatively minor contribution from revenue gains has seen per-share sales fail to exceed their pre-recession peak.
By way of comparison, profit gains during the previous earnings expansion that extended from the end of 2001 to the summer of 2007, were shared relatively evenly between margin improvement and revenue growth. Further, the quarterly year-on-year growth in sales-per-share averaged almost four per cent back then, as against just two per cent today.
It is important to appreciate that the magnitude of the economic downturn that accompanied the global financial crisis saw the corporate sector trim their cost structures to the bone. Troubling, the subsequent lukewarm recovery has seen little let-up in this regard, and though this may well have pushed both corporate profits and cash flow generation to all-time highs, but the reluctance to reinvest the gains in either human capital or productive assets has created a negative feedback loop that threatens not only to hold economic growth below trend, but also to lower the economy’s potential future growth rate.
It is fair to say that the ‘Great Recession’ sparked serious erosion in labour’s bargaining power that is likely to persist for the indefinite future. The unemployment rate surged to a peak of ten per cent in the autumn of 2009, as the corporate sector responded forcefully to reverse the sharp drop in profitability. However, the high rate of joblessness combined with unsustainable household debt levels to virtually assure nothing more than a modest rebound in final demand, which in turn, has led to a relatively jobless recovery.
Subdued job growth has seen the unemployment rate persist above eight per cent for more than forty months, and the downward pressure on real wages has seen the labour share of GDP drop to the lowest levels on record. The stagnation in household incomes means that final demand is sure to remain lacklustre, which in turn, means the unemployment rate will remain elevated. All told, high rates of long-term unemployment and the resulting erosion of human capital could well result in a loss of productivity and lower potential future growth.
The economic downturn had a pronounced negative effect not only on the labour market, but also on net new investment in the productive capital stock. Business investment dropped by than a fifth through the downturn, and though corporate cash flows have surged to the highest level on record, capital expenditures remain below their pre-recession peak, and have not recovered to their long-term average relative to GDP.
The current high return on corporate assets alongside historically low interest rates has not proved sufficient to generate a robust investment cycle, as high levels of macroeconomic uncertainty have kept most companies on the sidelines. In a nutshell, the relatively low investment rate could well lead to a decline in labour productivity with a corresponding fall in the economy’s sustainable growth rate.
The upturn in corporate profitability in recent years is undoubtedly impressive, but persistently high unemployment alongside a relatively low investment rate means that the economy’s sustainable long-term growth rate is in jeopardy. Investors are right to attach a low multiple to current earnings.