Buttonwood's notebook

BCA Research has some remarkable statistics in its research note on profit margins (no link available, I'm afraid). Since 1990, real domestic corporate profits in America have risen 200%, while real compensation for corporate employees has increased just 20% and real median family incomes are up just 2% (is this the American dream?). Since 2000, the relevant statistics are 80%, 8% and minus 5% respectively.

Profit margins in the non-financial sector as measured by ebitd (earnings before interest, tax and depreciation) are as high as they have been at any moment in the last 50 years. there was a big drop in margins in the 1970s as wage and commodity costs soared and it has only been in the past decade that profits have returned to 1960s level. what was remarkable about the 2007-2008 subprime crisis is the speed with which margins have rebounded.

BCA cites a number of factors to explain the rebound from aggressive cost-cutting, the use of technology, to a sharp rise in overseas margins arising from a weaker dollar and some "tax-planning" measures that routed profits to low-tax countries. On the basis of this analysis BCA concludes that

it will be extremely hard for margins to rise further from current levels. Yet the trend in margins tends to follow the economic cycle, so it would be unusual for margins to weaken sharply in the absence of a marked slowdown in the pace of economic growth.

Of course, a slowdown in growth might be just what's occurring at the moment.

So why haven't workers got more of the pie? The conventional economic assumption is that compensation should keep pace with productivity. But the productivity gains have accrued to employers not employees. However BCA find that if you compared compensation with corporate prices (which companies get from selling their goods), the fit is much closer than with the consumer price index. Corporate prices have risen slowly because they are dominated by capital goods, where technology and China have kept the lid on increases. The consumer price index, by contrast, contains a lot more services where international competition is more constrained. I am not sure that this explanation is entirely satisfying - companies sell services too.

For the lowest-paid workers, things have been getting worse not better as they spend more of their incomes on food and energy, where inflation over the last year has been particularly strong. The divergent trend between profits and incomes brings us to the Marxist question of whether demand eventually collapses because workers cannot afford to buy the goods that capitalists produce. This crisis was averted in the 1990s and 2000s because consumers borrowed money to maintain spending - an option that is no longer very popular. So if the economy is to prosper in the next few years, it seems likely that the workers will have to get a better deal - and profit margins will have to take a hit.

IMAGINE if, one year after the Tarp scheme was unveiled to bail out the banking sector, bank shares had been even lower than before. But that is the position of European government bond yields in the affected countries. The setting up of a bailout fund in May 2010 was not the "shock and awe" package that the authorities had hoped for.  Yields on Greek, Irish and Portuguese debt are all higher, not lower.

In part, that is because the EU has treated this as a liquidity issue, not a solvency one. They have hoped that buying time will create the scope for the government concerned to tackle their deficits and the banks time to protect themselves from default. (Similarly, the US authorities though that, after the rescue of Bear Stearns in the spring of 2008, the market would have braced itself for the failure of Lehman. That turned out to be wrong.) Private sector creditors may also be reasoning that the greater the level of official support, the more subordinated the claims of the private sector will become.

The most worrying element for the authorities is the two countries at the bottom end of this scale; Italy and Spain. They are much larger than the three countries that have already been rescued. But, as you can see, yields have been drifting up; the Spanish cost of debt is at a 10-year high. This can be an awkward spiral; the higher the cost of debt, the more difficult it is for countries to banish their budget; the more difficult it is to balance the budget, the higher the cost of debt. The heavy defeat suffered by the Spanish government in regional elections also indicated that electorates may not be willing to endure the kind of sacrifices demanded by creditors.

If Europe is headed towards a choice between default and fiscal union, we have already seen in Germany and Finland that electorates in creditor nations may not be willing to grant the kind of subsidies that debtors might require. 

UPDATE: Meanwhile, on the slowdown front, eurozone industrial orders fell 1.8% in March, and Belgian business confidence declined again (although a small country, Belgium is a useful bellwether, placed between the French and German giants). However the Ifo survey of German business sentiment held up well. One should also note that gold reached a new nominal high in euro terms; the currency bears have switched their attention from the dollar to the euro. Foreign exchange markets remain a battle of the weaklings.

AS LinkedIn closes its first day of trading on a valuation of 36 times sales, some of us can feel a wave of nostalgia coming on. Restricted float? Yep. Only 10% of the stock was on offer. New valuation method? Check. The FT says the stock is valued at "more than $100 per user". Remember "price-per-click" and all that nonsense? It is possible that your blogger is listed as one of those users; I had to join once to try and track down the landlord of some noisy neighbours. The revenue LinkedIn has (and will) generate from me is zero, save if it sells my name on a mailing list in which case the purchaser of that list will face a disappointment.

Back in 1999 and 2000, of course, it was argued that dotcom mania wasn't a bubble because investors were rationally pricing in the future growth prospects of the companies concerned.

But who are these rational men? The London Times today reports that Harold Camping, a former engineer and radio preacher, is predicting that the world will end tomorrow (rather a blow for those who bought LinkedIn shares) after a massive earthquake in New Zealand. All this was forecast in the Bible, Mr Camping has calculated, written a couple of thousands of years before New Zealand was discovered by Europeans and given that name. Some calculation.

Now, of course, these kinds of eccentrics come around quite regularly. More alarming was the paper's report that

30 to 40 per cent of (Americans) regularly tell pollsters that the Bible contains a specific timetable for the end of the world

If you believe that, a price-per-user ratio of $100 may seem quite reasonable. Now some academics would argue that there may well be naive investors in the market but they merely provide the cannon fodder for the smart money that drive prices back into line. But Sir Isaac Newton also thought he could calculate the end of the world by analysing the Bible text. He also lost a fortune in the South Sea Bubble.

So if one of the smartest men in history can be that irrational, what does that say about the rest of us?

UPDATE: Perhaps Mr Camping is onto something. Here is the Centre for Disease Control advising citizens on what to do in the face of a zombie apocalypse. For example

Plan your evacuation route. When zombies are hungry they won’t stop until they get food (i.e., brains), which means you need to get out of town fast!

Apparently, the advice also works for hurricanes and earthquakes. And Mr Camping might want his own evacuation route by Sunday.

SECOND UPDATE: In response to queries, I couldn't find the source of the poll quoted by the Times. But I did find this round-up of surveys saying that 24% of Americans thought the second coming would occur in their lifetime and that 52% thought it would occur between 2000 and 3000 CE indicating that they have a specific timetable in mind.

EVER since the publication of the book Irrational Exuberance, there have been critics of Robert Shiller's cyclically adjusted p/e ratio. The chart here is a reprint from my post two weeks ago but you can find all the data on the Professor's website.

It wasn't actually a new idea on Shiller's part. Ben Graham, the value investor who was Warren Buffett's guru, had suggested a similar measure, involving the averaging of profits over an extended period to smooth out the effects of the economic cycle. Investors were paying little attention in the late 1990s. As the chart shows, the US market in the late 1990s was even more overvalued than it was before the crash of 1929. This was not a welcome message at the time when analysts talked of a "new era" and even speculated that the cycle had been abolished.

But even though the Shiller p/e accurately predicted that the market was overdue for a fall, there are still many critics who today refuse to accept its message. That is because, as you can see, the ratio is close to one of its 20th century peaks in the mid-1960s, which preceded the long bear market of the 1970s.

The ratio presupposes that profits revert to some sort of a mean, at least as a proportion of GDP. Some critics argue that things have changed in that capital is strongly placed relative to labour, thanks to factors such as competition from the Far East and the decline of trade union power. But even if that were the case, the ratio ought still to be mean-reverting. That is because of the nature of capitalism itself. If profit margins are high, then new businesses will be created to try to capture those profits (or existing businesses will expand); the resulting competition will drive margins back down. High profit margins could be maintained in a world of monopolies but globalisation, the same factor cited by profit bulls, erodes monopolies; if Chinese competition is depressing wages, it is also affecting the prices charged by western manufacturers.

Stockmarket bulls prefer to look at the prospective price-earnings ratio, based on next year's profits. But there are many problems with this. First, analysts almost always forecast double-digit profits gains but profits cannot grow that fast in a world of 5-6% nominal GDP growth. The stockbrokers are very bad at forecasting downturns. In addition, bulls often use a sleight of hand that compares the prospective p/e (based on higher earnings) with the average of the historic p/e, based on the previous year's figures. Such comparisons are designed to make the market look cheap.

A more plausible criticism is that profits in the early 20th century were not calculated on a similar basis, so one is comparing apples with pears. But this argument is also unconvincing. After the events of Enron and WorldCom, one can hardly claim that profits are not manipulated today; surely modern executives, motivated as they are by share options, have the incentive to overstate profits whereas those in the early 20th century might have been trying to avoid the taxman and thus understating them.

A related argument is that valuations from the early 20th century are "irrelevant" because of world wars, depressions and the like. One could retort that valuations from the 1980s and 1990s are irrelevant because central banks were inflating a bubble. But the better reply is that one should only deal with the data presented; not exclude chunks of it. We can't predict events. People in 1910 didn't know they were going to have a world war and a depression in the next 25 years; Japanese investors in 1990 might have though they were set for two more decades of prosperity but they were wrong. 

For those who doubt the valuation measure, why not look at other long-term approaches. the dividend yield is not 100% reliable; in 1932, at the market low, the stockmarket yields was very low because dividends had been slashed. But by and large, a high dividend yield is a sign of a cheap market and a low yield an expensive one; the yield on the S&P 500, according to ThomsonReuters is 2.3%, at the bottom end of the range. (Careful about arguments that you should add in a bit for share buybacks; you should offset such purchases with issuance of new equity in the form of options.)

Another approach is the q ratio, outlined by Andrew Smithers and Stephen Wright in their book Valuing Wall Street, which came out at the same time as Shiller's opus. This compares the value of the market with the net replacement cost of corporate assets. It too is a controversial measure because of data issues but it has a mean-reverting logic of its own. When market prices are above asset values, it will be cheaper for investors to buy assets directly than it will be for them to invest in equities; arbitrage will eventually drive the two back in line. And the Q ratio, although compiled on a different basis from Shiller's approach, shows a remarkably similar picture of peaks and troughs, including the current overvaluation. 

In short, if you don't like what Shiller is telling you, it is because you are a bull who thinks "this time is different".

PS Finally, a couple of links. The first is a piece on the use of statistics and the dangers that face those who try to blog honestly on such a partisan issue as tax. Some of the stuff written on the DSK saga is quite amazing as my colleague Schumpeter points out in typically rollicking style. And there is more justified outrage here and here. As to the argument of the "intellectual" that that New York chambermaids arrive in brigades, not singly, words fail me but not this columnist.

LAST Friday's post showed that the global purchasing managers index (particularly for the service sector) was heading rapidly down towards 50, the flexpoint between expansion and contraction. There are more signs today. Bloomberg reports that analysts' forecasts for European profits growth have been revised down by four percentage points this year. Meanwhile, in the US, the Empire State index of manufacturing in New York fell from 21.7 to 11.9, including a fall in the new orders index. The OECD lead indicator has been turning down quite sharply.

David Shairp of J P Morgan Asset Management notes another sign; the real yield on the 10-year TIPS has dropped from 1.4% in February to 0.75%. By and large, one would expect real yields to reflect growth expectations. (The primary reason is probably that if growth expectations are high, then investors will want a more exciting asset class than index-linked bonds. The real yield will have to rise in compensation.)  The fall in real yields thus reflects concern about the growth outlook.

The case for slower growth is not yet overwhelming. For example, the latest evidence for American profits forecasts I have seen (dated early May) shows that forecasts are still being revised higher.

Still one has to wonder about those forecasts. American profits are relatively high as a proportion of GDP. Paul Marson of Lombard Odier also points out that US margins are currently high. Over the long run, one would expect margins to mean revert, if only because high returns on capital will attract new businesses and the subsequent competition will drive returns back down again. there is a very good and negative link, Mr Marson finds, between high margins and subsequent profits growth.

Over the next 5 years, current elevated margins imply negative nominal net profit growth.

But that won't be reflected in analysts' forecasts, since they never predict a downturn.

THE first quarter growth numbers from France and Germany were very impressive, even if they owed a little to a rebound from late 2010. But a look at the purchasing managers' index (see chart) is less cheery. It adds weight to the feeling that the recent fall in bond yields and commodity prices may be pointing to a slowdown. It is not yet inevitable. There was a similar fall towards 50 in 1998 (around the time of the LTCM crisis) and in 2003 that proved to be a false alarm. But if the PMIs keep falling...

AT LAST. The British government needs to borrow £150 billion a year but last July it withdrew one of its most popular products, index-linked national savings, apparently under pressure from the banks, who were worried about the competition. The certificates give a return that matches the rise in the retail prices index, plus a margin on top, tax-free. Since the RPI is up 5.5% year-on-year, that's a very good deal. Compare that with the best fixed rate on offer, according to moneysupermarket, of 4.01% for three years. Since the latter is taxable, that translates into 2.4% for middle-class investors on the 40% rate and 2% for the wealthiest. In post-tax terms, real rates for savers are highly negative.

The new range of certificates offers a real yield of just 0.5%, compared with the 1% that was on offer last July. That's perfectly fair; if there is a lot of demand for a savings product, then lower the return. They could have eliminated the real rate entirely and it would still have been a good deal.

There is always the chance, of course, that inflation may have peaked and that it will head sharply down if Britain slips back into recession. British savers (this blogger included) will be happy to take the risk. The Bank of England's job was to meet the inflation target and it failed; savers should have some way of insuring themselves against the possibility that it will fail again.

MERVYN King was on the news last night, welcoming the decline in the pound in 2008 and 2009 as a necessary adjustment to the economy. Gone are the days, it seems, when central bankers were guardians of the currency (first witness: Ben Bernanke).

Perhaps that's right. The Labour government of 1964-70 was holed under the waterline by its initial decision to defend the value of the pound, rather than devalue. The fear of prime minister Harold Wilson was that the Labour party, which had previously devalued in 1949, would be stuck with the label of economic failure. But the result was that the government had to introduce austerity plans which dismayed its core voters. In a sense, the government was stuck in a similar trap to that which faces Greece since the options did not look good either way.

As Dominic Sandbrook recounts in his entertaining history of the era, White Heat:

Wilson also knew that devaluation would inevitably be accompanied by severe cuts in public spending and a rapid slowdown in consumer growth in order to release economic resources for exports

Perhaps devaluation was more of a fear those days when most imports came in the form of raw materials and thus any fall in the value of the currency would mean a rise in inflation (a devaluation always represents a fall in the standard of living in some form).  The US worries less about this now because commodities are priced in dollars.

Anyway, the Wilson government had some colourful characters and this gives me an excuse to recount my favourite story from the Sandbrook book. George Brown, Wilson's number two, was a less puritanical figure than his modern namesake, Gordon, although they could both throw a fair share of tantrums. George was a notorious drunk with an eye for the ladies. At a reception in Latin America

George made a beeline for a gorgeously crimson-clad figure and said "Excuse me, can I have the pleasure of this dance?"

There was a terrible silence for a moment before the guest, who knew who he was, replied: "There are three reasons, Mr Brown, why I will not dance with you. The first, I fear, is that you've had a little too much to drink. The second is that this is not, as you seem to suppose, a waltz the orchestra is playing but the Peruvian national anthem for which you should be standing to attention. And the third reason why we may not dance, Mr Brown, is that I am the Cardinal Archbishop of Lima

A FEW weeks ago, my column was on debt denial. There could not be a clearer case of it today than in remarks by Christine Lagarde, the French finance minister, to Le Figaro about a potential Greek restructuring.

We totally exclude it in any form. Nor is there any question of Greece leaving the Eurozone. I want to reassure investors.

Of course, one recognizes that politicians may feel they have to say this sort of thing. Jim Callaghan, Britain's finance minister in 1967, made the mistake of prevaricating (rather than lying) ahead of sterling's devaluation that year, provoking a further run on the country's foreign exchange reserves. But as Martin Wolf argues in today's FT, it has been a year since the Greek bailout and the problem has not been solved; yields are higher than ever, and private sector investors now face a bigger loss since they have been subordinated to official creditors.

Your blogger spent all of Tuesday chairing the Economist's bellwether conference in London which featured historians (Niall Ferguson), economists (Glenn Hubbard) and bankers (Sir Win Bischoff). It was generally agreed that Greece had no hope of repaying its debts on its own and that the only alternative would be a push to fiscal union across the euro-zone. But that would be staggeringly unpopular with the German electorate which would have to foot most of the bill, and one doubts that Christine Lagarde could sell it to French voters either.

Alas, Greece is in a hopeless position. Leaving the euro would solve the competitiveness problem but as one speaker put it, Greece has no great industries that could take advantage. And euro departure would lead to inevitable default in any case, since its debts are denominated in euro terms. It would cause a financial crisis as Greeks took their euros out of domestic banks and stashed them overseas (it would be interesting to see whether this is happening already). Default would cut the Greeks off from the markets, requiring the country to balance its budgets meaning they would still have to impose an austerity programme. And euro departure might also cut the country off from official support from the EU.

Default within the euro would still leave the economy dependent on its neighbours but at least the Germans and the ECB would have a more secure claim since private sector claims would be heavily discounted. But the problem is what to do about the Greek banks that own government debt; they would need rescuing as well. Of course, the reason Ms Lagarde is so wary of Greek default is that it might prompt a further run on Ireland, Portugal and (worst of all) Spain.

Muddling through and hoping for the best is the strategy but it ain't going to work. The Greeks won't wear it (there's another national strike today); the markets won't wear it (three year Greek bond yields are nearly 25%); and German voters won't wear it either.

THERE are 26 stocks in the S&P 500 with a market value of more than $100 billion. According to Morgan Stanley, such companies are cheaper than they have been, relative to the rest of the market, in the past 25 years. In practical terms, this means they stand at an average 20% discount to the market's prospective price-earnings ratio. Since March 2009, the megacaps have risen 67% compared with the rest of the market's 118%.

Similar factors seem to be at play in Europe where, according to Newton, the biggest stocks (defined as those worth over €30 billion) have risen 60% since March 2009 while the rest of the market has more than doubled.

So what is going on? There is a potentially simple explanation for the underperformance since March 2009. During the crisis, investors will have flocked to the biggest names in the market for defensive reasons; once sentiment recovered, there was scope to find bargains in the small and midcap prices, some of which were priced as if they were going bankrupt.

However, that factor doesn't explain the valuation discount. there might be two other explanations.  The first could be the expectation that future growth will be generated by emerging markets; while many of the megacaps are exposed to such markets, it is a relatively small part of the business. Investors may be looking for niche plays in the small and midcap areas.  However, a second explanation seems more plausible. The moment when megacaps had the highest relative value was in 1999/2000 when the TMT stocks (tech, media and telecom) were much sought-after. Now, with the odd exception such as Google and Apple, the megacap sector looks less exciting (banks, energy companies, pharamaceuticals). These may be solid businesses but it is hard to spin a story of endless double-digit profits growth.

THE sharp sell-off in commodity prices yesterday seems to be continuing this morning (May 6th). It raises a whole set of questions, particularly as equities have sold off in tandem.

Surely a sharp fall in the oil price ought to be good news? The surge in petrol prices has acted as a tax increase on western consumers, and this fall will relieve some of the pressure on their wallets. Ole Hansen of Saxo Bank says the sell-off began when the first quarter GDP numbers from the US were weaker-than-expected; yesterday's higher-than-expected weekly jobless claims exacerbated the trend. However, one of the main bullish arguments for commodities was that emerging market demand was now driving prices; that was why prices had rebounded so quickly even though the developed world recovery was still pretty weak. There is no evidence, as yet, that the Chinese economy is faltering.

Given those fundamentals, the case for arguing that commodity prices have been driven to excess by speculators looks rather stronger. Silver is a case in point. Its strength owes nothing to fundamentals and a lot to investors seizing upon it as a "poor man's gold"; in one recent session, the silver ETF saw more trading volume than its S&P 500 equivalent. Silver's headlong rise looked very bubble-like and the CME futures exchange has increased margin requirements sharply; as Mr Hansen puts it, traders had the choice of putting up more cash or taking profits. They have clearly done the latter. (This just shows what can be done by the authorities to pop bubbles if they wish; if only lower loan-to-value regulations had been imposed in the US housing market.)

Nevertheless, the argument that the price rise is all down to speculators is far from proven. It is noticeable that agricultural prices have held up better than most, perhaps because weather patterns are affecting the US planting season. Oil aside, food prices are the key commodity class for developing country prosperity.

Is this the end of the commodity bull market? It is far too early to say that; there was a similar sell-off this time last year. Until demand from emerging markets slackens, or new discoveries are brought on stream, there seem likely to be bouts of upward pressure.

The equity market sell-off could be ascribed to the same weak growth numbers that sparked the commodity decline. Nevertheless, it does draw attention to the contradictions inherent in this long bull-run. Central banks are holding interest rates low (and using QE) because the economy is weak. But if the economy is weak, why have equity and commodity prices done so well?

CARMEN Reinhart (of This Time is Different fame) and Belen Sbrancia have a new paper on how governments have, in the past, eliminated debt via financial repression, defined as the maintenance of artificially low real interest rates via regulations and capital controls. The paper has already featured in a post from Free Exchange and is highlighted in the latest note from Bill Gross of Pimco (you can omit page 1 with his bathrobe reminiscence).

Reinhart and Sbrancia note that real interest rates in advanced countries were negative roughly half the time between 1945 and 1980 and this helped to reduce British and American debt by 3-4% of GDP a year. That obviously had an enormous effect in reducing the post-WWII debt burden.

As pointed out in previous posts, there are three main ways of getting out of a debt trap; growth, default or inflation*. Many people (including the gold bugs) think that governments will go for the inflationary option but the problem with that approach is that the markets can see it coming, and will drive yields up accordingly. For the US, with an average debt maturity of under five years, it looks a very difficult option to pull off. The bond vigilantes will be watching.

One way of heading off the vigilantes is to get the central bank to hold down yields via direct purchases as has happened in many countries. But another is to stop them from moving their money out of the way. That implies capital controls, a key element of the Bretton Woods system. As Free Exchange writes

But it's not clear that Bretton Woods can be duplicated. Thirty years of financial liberalisation has made markets broader, deeper, and more complex. It has also created strong constituencies in favour of liberalised finance, most of which were not dislodged by the crisis. Putting the genie back in the bottle will prove very difficult.

One of those strong constituencies, of course, is the financial sector which is already, as Pimco illustrates, starting to complain. The sector is a very effective lobbying machine, not least because it is a huge source of finance for Presidential candidates. The practical problems of restricting capital movements, in an age where money is shifted between accounts with a click of a mouse, is another issue. Nevertheless, as Reinhart and Sbrancia point out, it is possible to see some measures, such as higher bank capital ratios (creating a captive market for government bonds), as the first steps down this road.

My view for some time has been that the crisis will create one of those epochal shifts in the international financial system, akin to the abandonment of the gold standard in the 1930s or the collapse of Bretton Woods in the 1970s. Different systems juggle the elements of the trilemma; one can have fixed exchange rates, independent monetary policy and free capital movements but not all three. The gold standard forced governments to subordinate monetary policy to the demands of the exchange rate; Bretton Woods stabilised exchange rates at the expense of capital restrictions.  

We tend to blithely assume that the Chinese will adapt to western ways by liberalising their capital account and letting their exchange rate float. But the Chinese are the creditors now and the creditors generally set the rules, as the Americans did at Bretton Woods. Might developed governments accept the bargain of managed exchange rates and capital restrictions if this allowed them to reduce their debt burdens without taking too heavy a toll on the voters? It's just a thought.

* There is, of course, austerity; running a fiscal surplus for years and years to gradually reduce the burden. But the record is patchy; Greece, Ireland and Portugal didn't get far down this road before they needed an EU rescue. We shall see how well Britain copes when the cuts really begin to bite. Six tube strikes have just been announced for May/June and schools may be closed in the autumn.