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August 8, 2005

Profit Margins, Labor Costs, and Earnings Growth

John P. Hussman, Ph.D.
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Just a note: Next week, the 2005 Annual Report of the Hussman Funds will stand in place of my weekly market comment, and will be available on the website by Wednesday, August 17, pending approval by the Board of Trustees. The report includes an extensive letter to shareholders which discusses the Funds, the markets, and my views on the economy. It also includes full portfolio details for the Strategic Growth Fund and Total Return Fund, and information on fees, expenses, and performance. I strongly encourage shareholders to read the report. Again, the expected date of availability on the website is by Wednesday, August 17, and the report will be mailed within a few weeks as soon as printing is completed.

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Friday's employment figures came in with job growth just slightly higher than expectations, with continuing expansion in lower-paying sectors such as retail, and also new jobs in financial services, primarily relating to real-estate. Manufacturing employment declined again. No surprise there. The U.S. is still seeing demand for consumer goods (which is also reflected in a deep current account deficit). Meanwhile, the housing bubble, even if it's not durable over the long-term, is helping to add new jobs for the real-estate and financial services in the short-term.

What was slightly more surprising was the 0.4% jump in labor costs in the latest report. That figure drove the 10-year Treasury bond yield higher, and contributed to weakness in stocks as well. The upward pressure on labor costs is the real story in Friday's employment report, and it's not likely to be a one-month event.

Profit margins and stock valuations

I've noted over the past year that profit margins have been unusually wide, which places earnings well above their normal levels in relation to other fundamentals such as revenues, book values, and dividends. While the market appears richly priced even in relation to current earnings, it appears even more expensive on measures such as price/revenues, price/book, and price/dividends. In effect, high profit margins make price/earnings ratios look somewhat tamer than they actually would be on the basis of “normalized earnings.”

If you think about how stocks are priced, you'll find that the market generally counts profit margins twice when it determines stock values. The direct effect of high profit margins is that they elevate earnings, which clearly support higher stock prices, other things being equal. In addition, however, high profit margins imply high returns on equity and new investment (return on equity is simply earnings/book value). To the extent that companies retain their earnings, the market generally assumes that reinvesting those earnings at higher rates of return will generate faster growth. As a result, price/earnings ratios tend to be higher for companies that achieve strong returns on equity and investment. It's still necessary to distinguish between reinvested earnings and free cash flow (which is available to distribute as dividends or to repurchase stock), but the basic effect remains: high profit margins tend to increase both earnings and price/earnings ratios.

This treatment of profit margins is actually proper, as long as profit margins are “normalized.” If instead, investors simply price stocks on the basis of current profit margins, without asking where those profit margins came from, or where they are going, the result can be disastrous. The tendency to “double count” temporarily high profit margins has regularly ended terribly for investors when the elevated margins have ultimately reverted back to normal. Earnings get squeezed, price/earnings ratios get squeezed, and prices get crushed.

What does this have to do with labor costs? It's essential to recognize that the primary cost item to most businesses is employee compensation. In recent years, however, employee compensation has been tightly contained. In fact, the 3.5% annual growth in employee wages and salaries over the past 5 years is the lowest on record since 1947. That containment of labor compensation has been the primary force behind the recent growth of corporate profits. As depicted in the chart below, the ratio of corporate profits to employee wages and salaries has never been higher.

The difficulty, however, is that in a competitive economy, elevated corporate profits don't tend to last. To some extent, the ability to hold down wages and salaries has been supported by cheaply available imports from China and other countries, but it's difficult to find evidence that this is the main cause. Rather, the temporary elevation in profit margins is a regular, cyclical occurrence that the U.S. has experienced time and time again. The subsequent mean-reversion of those profit margins is equally predictable.

What does this mean for profit growth in the future? In the graph below, the blue line (left scale) depicts the ratio of GDP to corporate profits. Currently, profits are at historic high relative to GDP, so the blue line (GDP/corporate profits) is at a historic low. Unfortunately, the green line (right scale) depicts the annual growth rate of profits in the following 5-years. Note that the line stops 5 years ago since the calculation of 5-year growth from that point will require more data.

One thing should be clear from this chart. Elevated profits (low GDP/profits ratios) are regularly associated with sub-par profit growth over the following 5-year period. That's because profit margins are mean-reverting. At present, the current GDP/corporate profits ratio (left scale) implies a 5-year growth rate in corporate profits (right scale) of just about zero.

In all probability, a slowdown in profit growth will take the form of an increased share of revenue going to employee wages and salaries, and a smaller, more normal share going to the bottom line. Given that current stock market valuations are relying heavily on both high earnings and the maintenance of high price/earnings ratios, the gradual normalization of profit margins is likely to produce disappointing investment returns for buy-and-hold investors in the coming years.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and relatively neutral market action. As I noted last week, the apparently favorable breadth of the market (as measured by advancing versus declining issues) is an artifact of the strength in small-cap stocks. Breadth continues to be divergent among larger capitalization stocks. Meanwhile, the proportion of bullish investment advisors has surged to the highest level of the year, and interest rates are pressing higher.

So there's Aunt Minnie again.

In bonds, the Market Climate was characterized by moderately unfavorable valuations and moderately unfavorable market action. The shape of the yield curve clearly suggests expectations for increases in short-term interest rates to 4% and beyond in the months ahead. Meanwhile, credit spreads and the ISM Purchasing Managers Index, among other factors, are suggesting that there is probably no immediate economic slowdown emerging. Until we observe widening credit spreads and weaker ISM figures, then, the Fed is likely to focus on employment, capacity use, wage growth and other factors, and continue raising the Federal Funds target gradually on that basis. With regard to the stock market, however, further economic strength at this point is not likely to benefit earnings much. While revenues may improve, profit margins are vulnerable, as a greater proportion of those revenues can be expected to be directed to materials costs, labor compensation, and other expenses.


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