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January 22, 2007

Elevated Earnings

John P. Hussman, Ph.D.
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If one factor separates the bulls from the bears here, it is the confidence that investors place in earnings. In recent months, I've argued that profit margins are extremely high on a historical basis, primarily because labor compensation has stagnated in recent years – currently near the lowest share of GDP in history. If profit margins were at normal levels, the P/E on the S&P 500 would be about 25.

Importantly, over the past several quarters, wage inflation has begun to move higher, outpacing the rate of inflation at both the consumer and producer levels. This has quietly created an emerging threat to profit margins.

Now, most analysts are quick to point out that wages can, in fact, increase without creating general price inflation or hurting profit margins, provided that productivity is increasing. If workers are creating more output, then they can be paid a greater amount without necessarily affecting profits or overall price inflation. To account for this, it's important to measure wages per unit of output created by workers – so called “unit labor costs.”

Even adjusted for productivity, however, unit labor costs have picked up from zero in 2004 to close to 3% annual growth through the third quarter of 2006, and based on other wage data, are probably advancing well above that level at present.

While that might not seem like a major change, think of it this way. Suppose that a company pays 50% of its revenues out as labor compensation, and has a 10% profit margin after other costs. Holding output constant for simplicity (so that a rise in wages is also a rise in unit labor costs), a 2% increase in wage compensation (to 51% of revenues) will trigger a 10% reduction in the profit margin (to 9%). Clearly, wage shifts can have a great deal of leverage on profit margins, particularly when they are rising faster than general prices, as is presently the case.

Given the very low level of labor compensation as a fraction of GDP, coupled with a relatively low unemployment rate, it's likely that we'll continue to observe upward pressure on unit labor costs. Again, this is a threat to profit margins.

The chart below shows the general relationship between labor costs and profits in data from 1990 through the third quarter of 2006. Inflation in unit labor costs is plotted along the left scale (inverted, so a declining blue line means higher wage inflation). Profit growth is depicted by the green line, measured along the right scale.

Looking closely, you'll notice something very unusual about the past year. With unit labor costs already on the rise, we've actually observed strong growth in profits anyway.

As it turns out, such divergences have historically been dangerous. When we've observed such gaps in the past, they have almost invariably been closed by earnings moving in line with labor costs, not vice versa. Given present depressed levels of labor compensation and the resulting upward wage pressures, we can expect that profit margins will become increasingly difficult to sustain in the coming quarters.

The effect of energy and financials

Among the main factors delaying the impact of wage pressures is that an unusually large chunk of total corporate earnings has been represented by record earnings in energy (primarily oil) and financial stocks.

The effect of this is two-fold. First, the impact of higher unit labor costs is being temporarily diluted, so investors do not yet recognize the threat that rising labor costs pose to continued earnings growth. Second, earnings from energy and financials are also having the effect of suppressing the P/E on the S&P 500, making overall valuations look far more reasonable than they actually are.

As Tom McManus at Bank of America points out, “the apparently low price/earnings multiple of the S&P 500 depends on the energy and financial sectors; it should be apparent that the remainder of the S&P 500 is more expensive than is widely perceived, especially when one considers that revenues and profit margins have already enjoyed substantial cyclical improvement.”

Even on the basis of “operating earnings” that also reflect record-high profit margins, McManus provides the following picture. Since about 1998, energy and financial stocks have created an increasingly large gap between the observed S&P 500 P/E ratio and the (higher) valuation multiples of non-energy, non-financial stocks.

As another market observer recently put it, the earnings from the lowest P/E sectors (financials and energy) are being counted by investors and capitalized as if they are being earned by much higher P/E industries.

Again, the net effect of this is to provide an illusory comfort to current price/earnings multiples; a comfort that is both temporary and dangerous for investors taking prevailing earnings (or worse, “forward operating earnings”) at face value.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations, moderately favorable market action on the basis of prevailing price trends, but also an overbought, overbullish condition that has historically been associated with returns below Treasury bill yields. Add to that the fact that T-bill yields themselves are higher than they were 6 months ago, and we have a relatively rare syndrome that has almost invariably been associated with deep short-term market losses. That's not a forecast of what will happen in this particular instance, but it's about as close as you'll ever see me come to an outright warning about potential risks.

One question I receive from time to time is why we don't establish a significant short position during extremely negative market conditions, given for example, the historical tendency for market losses that have followed from overvalued, overbought, overbullish periods coupled with rising short-term interest rates. The reason is that half of disciplined investing is knowing what you're willing to tolerate if you're wrong - and few investors have much tolerance for actual, predictable losses in the event that the market advances unexpectedly.

Our most defensive investment position is one where the entire value of our stock position is hedged, generally using long-put / short-call option combinations (where no more than one of those options is “in-the-money” at the time the position is established). That leaves us a small amount of latitude in our effective exposure to “local” market movements, depending on factors like the “beta” of our stocks, the strike prices of various options, and so forth. I don't, however, establish positions that I would expect to predictably experience sustained losses during an unexpected advance. There are “bear” funds that do accept that sort of risk, but we are not among them.

In general, we take two kinds of risk: a) broadly diversified stock selection, which carries the risk that our stocks will perform differently than the market (this has historically been a significant source of long-term return for the Fund), and b) exposure to general market fluctuations, when appropriate. While we accepted a significant exposure to market fluctuations in 2003, valuations since then have been rich, and market action has only periodically supported a speculative exposure. The present overbought, overbullish conditions support no speculative exposure at all. Even so, I strongly expect exposure to market fluctuations to contribute to our full-cycle returns over the long term.

For now, the Fund remains fully invested in stocks that I believe demonstrate favorable valuation and good sponsorship from other investors, with the market risk of those positions defensively hedged, for reasons that I've emphasized in recent weeks.

In bonds, the Market Climate remained characterized last week by unfavorable valuations and relatively neutral market action, holding the Strategic Total Return Fund to a short duration of about 2 years, mostly in TIPS. The Market Climate for precious metals remains favorable. The U.S. dollar has enjoyed a good clearing rally from its oversold conditions in early December, so any resumption of dollar weakness will separately be helpful for precious metals shares as well. The Fund continues to carry a position of about 20% of assets in those shares.

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