I don't normally post "pay" articles, but this one is a really nice summary of our bubble. The real article at Grant's Investor has a bunch of pretty pictures to go with it.
REFLECTIONS ON THE BOOM
by Bridgewater Associates
12:30 PM 10|25|2000
A surge in fixed investment has worked its magic on
earnings, stock prices and wealth in general. But the signs
point to an overextended boom. Can anyone say bubble?
Since the beginning of 1994, the U.S. economy has been in the
midst of a sustained investment boom that has driven earnings,
stock prices and wealth substantially higher. Specifically, during this
period business fixed investment rose by 90%, corporate profits
rose by 150% and stock prices rose by 200%. In addition, despite
unchanged interest rates, the price-earnings multiple on the S&P
500 rose by 20%. In other words, even if P/Es had remained
unchanged, stock prices would have risen by 150%, and their
annual rate of ascent would have been 14.6% per year instead of
17.6% per year. The main reason that stock prices have risen is
because earnings have risen.
You can break earnings growth into two main pieces, the change in
revenue and the change in the net profit margin as a percent of
revenue. By definition, the combination of the two pieces will give
you the change in net profits. Between these two pieces, we
estimate that changes in margins drive about 85% of the change in
earnings, while changes in revenue drive about 15% of the change
in earnings. For example, the following chart shows the three-year
change in nonfinancial corporate profits and the three-year change
in net profit margins. As you can see, changes in profit margins are
96% correlated with changes in profit growth. Since 1994, margins
have risen, first by a lot and then by a little. The biggest surge in
corporate profits occurred in the mid-1990s, when margins rose
the fastest.
On the other hand, changes in revenues are only 25% correlated
with changes in earnings. Since 1994, revenues grew steadily
between 6% and 7%. Without the rise in profit margins, earnings
growth would have been much slower, closer to the long-term
average of 7% per year.
While a lot of factors drive margins, there are three big ones ... new
investment, interest expense and labor margins. We will address the
role that each played in the recent investment/profit/stock-market
boom.
By new investment, we mean fixed investment in excess of what is
required to replace worn-out fixed capital. This is approximated by
new investment less depreciation, where depreciation is expressed
in terms of replacement cost. New investment impacts margins
because new investment front-loads revenues relative to expenses
across the corporate sector. For example, if company A sells a
machine to company B for $100, company A recognizes a $100
revenue while company B only recognizes a fraction of $100 as an
expense. This creates a surge in reported profits in the year of the
investment. A sustained investment boom will lead to a number of
years in which profits are front-loaded. But when the boom stops
accelerating, profits slow dramatically as the back-end expenses
rise faster than the front-end revenues. For example, since 1970,
profits across the G-7 plus Australia grew by 16% per year during
the early phase of investment booms but only grew by 3% in the
latter phase of investment booms.
...[N]ew investment has had a substantial impact on profit margins
for 40 years. And the surge in new investment since 1993 has had a
lot to do with recent margin expansion. ...[T]he recent surge in new
investment started ... when investment as a percent of revenue was
at a very low level. In other words, one perspective on the
investment boom is that it was first a return to normalcy, then
momentum carried it beyond normal. Now, investment as a percent
of revenue is near a 40-year high. It has not yet decelerated, but if it
does, profit margins and profit growth will suffer.
The second major driver of margins is the interest burden. As
shown below, the interest burden (shown inverted) fell substantially
in the early 1990s and then stabilized. This helped margins. Now
we see that the interest burden is starting to rise again, eating into
margins.
At the beginning of the current investment boom, corporate debt
levels were at cyclical lows. In the early 1990s, companies were
not investing and were awash in cash, so they paid down their
debts. From 1993 to 1997, debt relative to revenue was stable at
these lower levels. This, combined with stable interest rates, kept
the interest burden stable. But ... recently, the debt burden has
grown more rapidly [and], combined with higher corporate interest
rates, has started to push the interest burden higher. ...[P]rofit
growth and profit margins are somewhat dependent on an
acceleration of new investment. A further acceleration of new
investment and M&A activity would require more debt, which
would push debt as a percent of revenue, and interest as a percent
of revenue, even higher, biting into profits. Changes in interest rates
would also have an impact.
The third major driver of profit margins is the margin on labor.
More specifically, one [that is] minus the cost of labor as a
percentage of revenue. ...[T]he early phase of the current
investment boom was accompanied by a rising margin on labor. At
that time, corporate layoffs fostered job insecurity, which helped
companies to hold down real wages relative to productivity growth.
But in the past few years, labor markets have tightened and job
security has risen, allowing real wages to catch up to prior and
current productivity increases. ...[I]n the past three years, the labor
margin has been flat despite the huge rise in productivity.
Focusing a bit further on the margin on labor, we see a familiar
pattern. At the beginning of the current investment/profit boom, the
margin on labor was at a low level. It initially rose to and then
above its long-term average, and then stabilized. To some extent,
the replacement of people with machines and software supported
this rise. In addition, the general trend toward more conservative
economic policies also supported the move.... Now, the margin on
labor is near its 40-year high. Going forward, a reversion to the
norm would substantially hurt profit growth. A leftward shift in the
political winds would hurt profit growth. A continuation of prior
trends to new highs would boost profit growth. Our cross-country
study of productivity and real wages suggests that the labor margin
is somewhat bounded ... but that movements within these bounds
can have substantial impacts on profit growth.
...[T]hese three drivers together ... account for 86% of the
variability in profit margins over the past 40 years and fully explain
the rise in profit margins since 1993. As discussed above, during
the current investment boom, all three of them (a) started at low
levels, (b) rose substantially and (c) are now at high levels. Given
this, extrapolating past earnings growth into the future seems
dubious. Such profit growth would require a continued expansion
of margins. This, in turn, would require some combination of a
further acceleration in new investment despite a relatively tight Fed
policy and diminished availability of dot.com equity financing, falling
interest burdens despite rising debt levels, and rising margins on
labor despite extremely tight labor markets. The odds of such an
event seem low. The opposite seems more likely.
What about productivity? As [stated] above, 86% of the change in
corporate margins can be explained without reference to
productivity. As we have [noted before], productivity is important
in two respects. First, if productivity rises faster or slower than real
wages, the margin on labor changes proportionately. So, with
respect to margins, productivity cannot be viewed in isolation; it
must to compared to real wages. And as we've shown in the past,
the overwhelming tendency across countries, especially in the
free-labor-market U.S., is for real wages to rise or fall over time to
match productivity with nearly one-to-one precision. This makes
the margin on labor much more important than productivity. As a
case in point ... the rise in the labor margin in the mid-1990s
occurred when productivity growth was meager but real wage
growth was very weak. Whereas in the past three years, when
productivity growth accelerated, the margin on labor remained
stable because real wages kept pace with this rise in productivity.
The second way in which productivity matters is that higher
productivity produces higher real wages, which leads to higher
spending, which leads to higher revenue growth. This is the main
benefit of productivity on earnings. But this revenue impact of
productivity growth only creates small changes in profit growth,
essentially 1% profit growth for 1% productivity growth. The
revenue impact of a surge in productivity will be insufficient to
produce earnings growth such as we've seen in recent years.
The more we study it, the more it looks like the U.S. economy is in
a bubble rather than a boom. Or, more specifically, an
overextended boom that has turned into a bubble |
