- Pricing power has improved and stabilized at the mean.
- The profits/wage cycle turned negative (for profits) in March.
- Net margins have peaked.
- The S&P's market value has finally caught up to earnings.
Tactical allocation strategies primarily depend on (among other things) knowing when risky assets provide sufficient prospective returns to justify their uncertainty. Here are a few factors based upon long term cyclical trends that we consider in the models that drive Sandpiper Capital's allocations. They are sending a message that is becoming certainly less bullish. No one knows when investor sentiment will turn, but we do know when the economic fundamentals have. I would expect that increasing one's cash reserves is now warranted.
When S&P 500 companies have been consistently able to raise prices relative to their cost of goods sold, investors would do well to notice. In the graphic below, the light blue dashed line is a twenty-five year history of the trailing twelve month gross margin (profit after cost of goods sold) for the stocks in the S&P 500. The dark blue solid line is the total market capitalization including debt but less cash (or enterprise value) relative to cash flow.
Think of this as a more inclusive price to earnings ratio. Whether improving demand relative to supply or abating competitive pressures or an increasingly productive workforce, the inputs that result in improving gross margins have historically been longer term trends around a central tendency. The period of 1994 through 2000 showed a remarkable confluence of these factors, (abetted by a Y2K scare capital spending cycle) that was the rising tide that lifted a lot of boats. The current recovery cycle has certainly been more muted with pricing power only now slowly stabilizing at about its twenty-five year average (the thin red horizontal line) with market values at what look like about fully priced levels. (click to enlarge)
The Labor/Profit Cycle and Net Margins
One of the major expenses that companies face is the cost of labor and one of the most important factors behind the consistently improving peak net margins that corporations have been enjoying is their increasing political power versus wage earners. The return on investment for corporate spending on lobbying (both the public and politicians) is exponentially greater than that of most competing uses of free cash flow (one study cites about a 220:1 return). The concomitant cultural shift that spending has purchased has helped move popular sentiment away from support of wage earners and in favor of "free enterprise".
The reality is that in each successive economic recession, S&P 500 companies have emerged more profitable than before as furloughs and layoffs reduced the ranks of better paid employees, subsequently substituting lower cost ones during the recoveries. There has been evident in the previous few cycles an inflection point, where either the next hire is expensive enough (and the ability to wring one more tax benefit out of the system is difficult enough) or the willingness of the government to subsidize demand for one more month is dissipating fast enough, that the cycle away from peak profits begins anew. We may have seen the beginning of that shift last quarter.
One good way to picture the profits/wage cycle is to look at the Commerce Department's national income account numbers. In the chart below, the black line is simply a moving average of the ratio of domestic companies after-tax profits for each quarter divided by total domestic wage income. A flat line would indicate that each was increasing or decreasing at the same rate. The cyclical nature of the relationship between profits and wages illustrates the limits of how far labor efficiencies (and tax policy) can take profit margins, (illustrated by the blue line). Pay people too little and (unless the government boosts demand by printing money) the economy slows because of too little discretionary income to the people who buy things. Pay them too much, well, that problem hasn't come up because of an almost unlimited pool of substitute labor. There is a cycle however, that is captured by the first quarter's turn in this ratio where you'll see an abrupt shift in favor of labor. This particular quarter was influenced by the weather (climate) more than anything else, as demand was temporarily slowed. The preliminary second quarter numbers show no bounce back in this ratio however, giving anyone attempting to anticipate the next few quarter's S&P earnings some pause.
(click to enlarge)
The S&P 500 Has Caught Up to Earnings.
The graph below shows the price of the S&P 500 (in green), the trailing reported twelve month earnings for the S&P 500 (in black) and our proprietary profits index (the purple line) all normalized to the same scale on the right. The profits index aggregates reported productivity, industrial production, financial leverage and pricing power together into an index that captures the direction of these major factors in profitability. The relationship between the price of the market and its earnings had stayed fairly tight over the first part of the last decade with valuations lagging earnings on pessimistic sentiment until late last year. With most factors which determine profits on balance flat, I would expect that a market adjustment that corrects recent exuberance is probably in the cards.
The market reality going forward should be much as it has been in the past. A precarious and mature economy results in more frequent and sharper earnings cycles around a increasingly flattening trendline. That is, for a buy and hold index fund investor, a forward market return through the whole cycle that is the same as the market return if you bought at the peak of the last two economic cycles, 3% to 6% per year. Reducing allocations this year is a prudent step given expected recurring volatility.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.