Earnings’ fun-house mirror: James Saft

April 30, 2013

By James Saft

(Reuters) – U.S. corporate earnings appear as if reflected in a distorting fun-house mirror: profits are huge but revenues strangely shrunken.

Corporate profits have grown strongly, up 2.1 percent among S&P 500 companies reporting first-quarter earnings so far, with 70 percent exceeding analysts’ expectations. At first glance, that looks like a particularly good outcome, especially considering profits compared to the size of the economy are near recent all-time highs. Revenues, however, are falling; down 0.6 percent compared to a year ago, marking the second quarter out of three that cash coming into corporate coffers has shrunk.

Understanding how this unsustainable state came to be and how long it might go on is the key to knowing not just what will happen with stock markets but perhaps with the economy itself.

So, how are companies keeping more and more of the less and less in revenues that flows in their doors? In part through efficiency, but in part the old-fashioned way: by not investing for the future.

Historically profits and investments have been fairly tightly connected, with companies seeing high margins as a signal to invest in new capacity and make more. The extra capacity from the investment means more competition, which in turn drives down margins.

Yet since 2000 investment has decreased to levels not seen since the Great Depression; all the while profitability has hit and exceeded all-time peaks. Economist Andrew Smithers has argued that low investment is driven by the compensation culture at corporations, where executives are paid to drive stock prices up over the two to five years before their stock options expire. Why make a 15-year investment in new equipment when you, the CEO, will be out the door in five or seven years?

If true, this implies a hollowing out of the productive capacity of companies as their investments age. For a drug maker, for example, you might get great profits now but a fall over time as patents expire and low investment into research means they are not replaced by new discoveries.

“It is as if corporations view their current profitability as a windfall rather than a permanent condition,” Ben Inker of fund manager GMO writes in a note to clients.

“Viewing the profits as a windfall certainly isn’t irrational, but it is surprising for corporations that have been living in a world of high profitability for close to two decades to be so cautious.”


Of course corporate profits are also driven by government and household savings, as well as the current account deficit. In essence the more people and the government saves the less money there is flowing through corporate accounts. Thus deficit spending and consumer borrowing have been crucial to keeping profits high, with the two sectors combined taking their savings rate since the financial crisis to a quite unsustainable negative 5 percent neighborhood.

That’s great for profits, but not, as they say, a long-term solution.

Consider the healthy 3.2 percent increase in consumer spending in the first quarter, despite a payroll tax hike in January of about 2 percent. That’s more money for the government, but consumers funded the spending mostly by cutting back on savings, taking their savings rate to 2.6 percent, hardly the kind of rate needed to finance retirement.

If the government gets serious about deficit reduction or if households decide to save more, profits, all else being equal, will have to fall.

So, we have a quite extraordinary set of circumstances. Profits are in record territory, but revenue is shrinking, all courtesy of the kind of borrowing by government and consumers which meets fully the definition of unsustainable.

Perhaps the lack of investment is thus a justifiable lack of faith in the whole set-up.

Inker of GMO argues that it could go on forever without higher investment, but perhaps in ways which would not be acceptable to many in society. After all, those profits come back to investors via dividends, much of which go to the well-off and some of which are recycled as consumption.

“There may not be enough goods and services for the rich to buy to make this work, but even if it were possible, it would almost certainly increase the resentment of the have-nots until they took it out on them through the ballot box, if nothing else,” he writes.

Monetary policy too is helping, but only helping consumers spend more than they truly ought to, rather than helping to encourage businesses to invest. The economy seems locked in a self-perpetuating cycle of borrowing, spending and asset inflation, without the fundamental investment needed to increase real growth.

Perhaps the economy and stock market can go their merry unsustainable way for a while yet, but betting on it seems to carry more risk than reward.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)


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