Macro - Corporate Profits as a % of GDP

[Blake Hampton]

Right now, corporate profits as a % of GDP are at a historical all-time high of around 11%. I have a couple of questions.

 

• Will this figure not revert back towards the mean of 6%, be it through lower earnings or higher corporate taxes? (Higher corporate taxes would help to pay down the record levels of US national debt, around 120% of GDP)
• What could it possibly mean for the US stock market overall?
• What additional thoughts do you have on the subject?

 

Source: https://fred.stlouisfed.org/graph/?g=1Pik

Edited March 28, 2023 by blakehampton
Needed to add additional details

[Cigarbutt]

In 1999, someone who knew a thing or two about investing ventured the following:

"In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn't going to happen."

So, potential conclusions:

-A macro 'opinion' does not prevent very reasonable outcomes otherwise?

-It's hard (impossible?) to reliably profit from a macro 'opinion'?

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Irrelevant personal addition:

i'm reading a book titled Chasing Daylight about a KPMG CEO whose lifespan shortened all of a sudden. The author discusses when he met Warren Buffett and how baffled he was to hear (in informal and impromptu discussions) Mr. Buffett's informed and substantiated opinions about very specific accounting standards. So if you're into that type of rabbit hole, you may be interested by the Kalecki equation which ties corporate profits and the rest of the world (a concept which is also the driver behind recent legislative noise concerning the taxation of buybacks etc). Of course, if that concepts holds any water, fiscal deficits have helped in sustaining corporate profits, a situation quite obvious for some time and especially since 2020 when corporations were able to pass-through increasing and printed costs while corporations and consumers were both subsidized to record levels.

The Kalecki Profit Equation: Why Government Deficit Spending (Typically) MUST Boost Corporate Earnings – Economist Writing Every Day

[KJP]

1 hour ago, Cigarbutt said:

----

Irrelevant personal addition:

i'm reading a book titled Chasing Daylight about a KPMG CEO whose lifespan shortened all of a sudden. The author discusses when he met Warren Buffett and how baffled he was to hear (in informal and impromptu discussions) Mr. Buffett's informed and substantiated opinions about very specific accounting standards. So if you're into that type of rabbit hole, you may be interested by the Kalecki equation which ties corporate profits and the rest of the world (a concept which is also the driver behind recent legislative noise concerning the taxation of buybacks etc). Of course, if that concepts holds any water, fiscal deficits have helped in sustaining corporate profits, a situation quite obvious for some time and especially since 2020 when corporations were able to pass-through increasing and printed costs while corporations and consumers were both subsidized to record levels.

The Kalecki Profit Equation: Why Government Deficit Spending (Typically) MUST Boost Corporate Earnings – Economist Writing Every Day

 

Wynne Godley and his disciples have developed a similar analysis.

[mattee2264]

• Will this figure not revert back towards the mean of 6%, be it through lower earnings or higher corporate taxes? (Higher corporate taxes would help to pay down the record levels of US national debt, around 120% of GDP)

Not necessarily. Higher profit margins to some degree reflect changes in the structure of the economy and also the degree of competition/concentration in industries. Technology especially has a winner takes all set up so that the success stories can make incredible profit margins while their dominance lasts. Competition law has become completely toothless and lots of mergers and acquisitions have been allowed that shouldn't have been. And of course technology companies generally have good pricing power, are asset and labour light etc. 

 

But of course some of the operative factors are reversing such as on-shoring, potential for higher corporate taxes, higher interest rates resulting in higher finance costs, and if workers learn to flex their muscles to get inflationary pay increases they might be able to bargain for a bigger share of the pie going forward and so on. So I think profit margins could fall below 10% but remain well above 6%. 

• What could it possibly mean for the US stock market overall?

Revenues won't grow much more than nominal GDP say 5% a year. If profit margins are declining then corporate earnings will be growing much slower. Especially if it is a lot harder for companies to do the ZIRP trick of buying back vast quantities of stock financed by borrowing at near zero interest rates. So I would say the set up is for lower returns going forward until margins stabilize at a new normal. 

• What additional thoughts do you have on the subject?

Be very careful about opining on what is normal based on historical evidence. There is always a new normal. Also even if a situation looks unsustainable it can persist for uncomfortably long periods of time. And even when we do reach a new normal it will take a number of years until you can say with any certainty you have reached it. And then conditions will change again. 

[StevieV]

3 hours ago, mattee2264 said:

• What additional thoughts do you have on the subject?

Be very careful about opining on what is normal based on historical evidence. There is always a new normal. Also even if a situation looks unsustainable it can persist for uncomfortably long periods of time. And even when we do reach a new normal it will take a number of years until you can say with any certainty you have reached it. And then conditions will change again. 

 

I agree with this.  Particularly the comments on historical evidence and timeframe.  History can be a guide, but 6% isn't a law of nature.  Also, corporate profits as a percent of GDP broke out above 6% over 20 years ago.  That's too long to be useful even if it were to mean revert.  Reminds me a bit of the Shiller PE.

 

I think the best one can say is that there is a risk of shrinking margins and, as mattee says, the possibility of lower future returns (again similar to the Shiller PE I guess).

[changegonnacome]

On 3/27/2023 at 8:13 PM, blakehampton said:

Right now, corporate profits as a % of GDP are at a historical all-time high of around 11%. I have a couple of questions.

 

• Will this figure not revert back towards the mean of 6%, be it through lower earnings or higher corporate taxes? (Higher corporate taxes would help to pay down the record levels of US national debt, around 120% of GDP)
• What could it possibly mean for the US stock market overall?
• What additional thoughts do you have on the subject?

 

 

The lack of capital required by some modern businesses leads to overall sustainably higher corp. profits.....this plus the nature of winner takes most software verticals.....means i think higher percentages are here to stay to a certain extent but perhaps not this high........the only way they fall IMO is that certain 'winner take all' business models get identified as such and get broken apart by anti-trust or I think overall Federal taxation will increase on a specific grouping of US mega-cap tech companies which if not broken apart will find themselves in some special taxation bucket.....a little bit like BEPS projects attempted to target only large revenue groups for a minimum global corporate tax rate........so think FANGMA in a US taxation terms..

[bizaro86]

@Cigarbuttthanks for posting the Kalecki piece. That was very interesting. It isn't really intuitive but does math out when you think about it - which likely means I learned something!

[Cigarbutt]

On 3/30/2023 at 10:07 PM, bizaro86 said:

@Cigarbuttthanks for posting the Kalecki piece. That was very interesting. It isn't really intuitive but does math out when you think about it - which likely means I learned something!

It's actually an interesting accounting identity (with potential insights) but (apologies to Kalecki, Levy, Godley and all) there is a fundamental flaw. 

i understand that your training is at least partly 'scientific' so when this accounting identity is formed, there is a giant assumption about the identification of the dependent variable (corporate profits) as a function of a whole set of other assumed independent variables and this is obviously not the case in the real world. Higher profits per unit of revenue may be the result of other factors (less competition?, more mature economy?, more 'mature' population?). Also, the equation does not take into account the dynamic nature of the interactions. For example, in the late 19th century, US corporations reported lower profits as a consequence of high levels of investments which meant higher profits to come.

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Back to the real world

Let's say you have a business (ie real estate leasing). You may increase profit margins by exploiting easy money, cheap leverage/taxes and by reducing leasehold improvements but that may point to future lower profit margins even if reversion to the mean may be blurred by 'transitory' issues?

[bizaro86]

13 hours ago, Cigarbutt said:

It's actually an interesting accounting identity (with potential insights) but (apologies to Kalecki, Levy, Godley and all) there is a fundamental flaw. 

i understand that your training is at least partly 'scientific' so when this accounting identity is formed, there is a giant assumption about the identification of the dependent variable (corporate profits) as a function of a whole set of other assumed independent variables and this is obviously not the case in the real world. Higher profits per unit of revenue may be the result of other factors (less competition?, more mature economy?, more 'mature' population?). Also, the equation does not take into account the dynamic nature of the interactions. For example, in the late 19th century, US corporations reported lower profits as a consequence of high levels of investments which meant higher profits to come.

-----

Back to the real world

Let's say you have a business (ie real estate leasing). You may increase profit margins by exploiting easy money, cheap leverage/taxes and by reducing leasehold improvements but that may point to future lower profit margins even if reversion to the mean may be blurred by 'transitory' issues?

 

I don't think profits are described as per unit of revenue, rather total profits. Obviously margins (and especially capital efficiency) matter for investors but I don't think you can generalize that this says anything about margins, except that when profits grow margin expansion is one of the more likely ways for that to happen. 

 

I also don't think (since its economy wide) it says anything about which businesses will earn those profits. As an example, the "investments" made by VC backed firms in the last few years would increase the amount of profits in the economy. However, those profits are probably not mostly earned by the VC owned startups, they were probably mostly earned by people selling fancy office furniture, Silicon Valley real estate, and (especially!) online advertising. Of course, in the long run misallocation of capital is a bad thing, mostly because it will tend to depress future investments once the misallocated capital is written off. Whereas successful investments into productive capital goods are likely to increase future investments. 

 

Anyway, like I said I appreciate you sharing this. The scientific part of my brain likes the "identity" part of it, and simplifying assumptions are OK with me - it's usually more important to understand the assumptions than the conclusion so you don't try and stretch something to where it doesn't apply. 

[Cigarbutt]

19 hours ago, bizaro86 said:

...

I also don't think (since its economy wide) it says anything about which businesses will earn those profits...

That may be one of the reasons why a top-down approach is difficult to apply in order to appropriate some of those profits at the individual stock holder level.

i've been following (with some dismay) Restoration Hardware (RH, a high-end furniture retailer) and seen margins go up and missed the boat in this Great Gatsby economy.

i guess it's ok to accept missing some boats. In the past, i've had interesting results (process and outcome) investing in furniture retailers (GBT BMTC group, holding period return helped by increasing margins 1+ but mostly through superior capital allocation and sustained buybacks below intrinsic value and The Brick, when margins went from negative to positive, often a very helpful development, if achieved).

And yes, one has to wonder at the possibility of a systemic misallocation of capital but what do i know?