Wall Street’s recent profit problems are likely to persist.
That’s the view from Research Affiliates or RAFI, a firm that oversees strategies for $154 billion in assets—chiefly index funds and ETFs. In recent piece “Peak Profits,” RAFI’s chief investment officer Chris Brightman makes a compelling case that we’re entering a new era of shockingly sluggish growth in profits. Put another way: Corporate America’s fantastic rise in profits during the past quarter century has run its course.
Over that period, U.S. manufacturers benefited from an ideal confluence of forces. The rise of China, India, and Eastern Europe opened a market of three billion new consumers for America’s cars, air conditioners, elevators, and mobile phones. At the same time, the climate for costs couldn’t have been better. Competition from workers in developing countries depressed labor costs in the U.S., while constantly falling interest rates provided a powerful tailwind. Many U.S. companies moved their headquarters to low-tax nations, notably Ireland, holding the share of profits claimed by the U.S. Treasury in check.
As a result, earnings per share grew at a tremendous 3.3% real rate from 1990 to 2014, more than double the number for the past 127 years, and far exceeding the rise in GDP.
The banquet ended in late 2014, when S&P profits reached a peak of $106 a share. Since then, the flagging demand from China for our energy and raw materials, and the gigantic surge in supply of oil, natural gas, and minerals, have combined to devastate profits of U.S. oil and mining companies. From the crest in the third quarter to the end of 2015, energy profits sank 186%, well into negative territory, while materials producers suffered a 74% decline. The two sectors alone accounted for all of the 12% fall S&P 500 profits.
So how much did the drop in earnings punish stock prices? Not much. From Q3 2014 to today, the S&P has shed just 2% of its value. Because earnings shrank a lot less than prices, price-to-earnings multiples—a good measure of whether stocks are overpriced or a bargain—actually rose from 18.6 to 21.
Brightman advises investors not to confuse the what’s temporary, which is the collapse in energy profits, from what’s enduring, which he predicts will be a dramatic downdraft in future profits. The depressed prices of oil, copper, and bauxite will eventually rise above costs of producing them, restoring much if not all of their producers’ profits. The problem is that we’re about to witness a big catchup in wages relative to earnings, reversing the trend of the past 25 years. “If you’re investing over many decades, what counts is overall economic growth,” says Brightman. “But if your horizon is a decade or two, there are long periods where earnings per share grows slowly or not at all.” Those profits, he says, will make up a far smaller portion of national income going forward, as labor costs begin rising once again. Political pressure to reduce income inequality is growing. And economic gravity, driven by renewed bidding for workers and rising wages in the emerging markets, will drive wages up back to their, higher, traditional share of GDP.
It’s probable that higher corporate taxes and interest rates will add to the drag. Indeed, a period where corporate profit growth outpaces GDP, and takes a bigger and bigger share, is highly unusual—and can’t last. Over extremely long periods, overall profits do rise with GDP, but individual companies’ earnings-per-share grow at a far slower rate, for two reasons. The first is dilution. Companies issue new shares to expand, acquire and effectively pay for stock grants to their managers. Second, new enterprises enter the market, so that more and more companies compete for the same customers.
For at least the next decade, if not longer, Brightman predicts that earnings-per-share, adjusted for inflation, will rise just 1.3% a year. That’s around 3.3%, assuming 2% inflation. In the early 1990s, economist Milton Friedman warned me that when profits grow to an unusually high portion of national income, they’re bound to retreat to the norm. Uncle Miltie would definitely endorse Brightman’s analysis. Wall Street’s salesmen keep pitching like polyannas, but the math—and history—don’t lie.