Excerpt from fund manager John Hussman's weekly essay on the US market:
If one factor separates the bulls from the bears here, it is the confidence that investors place in earnings. In recent months, I've argued that profit margins are extremely high on a historical basis, primarily because labor compensation has stagnated in recent years – currently near the lowest share of GDP in history. If profit margins were at normal levels, the P/E on the S&P 500 would be about 25. Importantly, over the past several quarters, wage inflation has begun to move higher, outpacing the rate of inflation at both the consumer and producer levels. This has quietly created an emerging threat to profit margins. Now, most analysts are quick to point out that wages can, in fact, increase without creating general price inflation or hurting profit margins, provided that productivity is increasing. If workers are creating more output, then they can be paid a greater amount without necessarily affecting profits or overall price inflation. To account for this, it's important to measure wages per unit of output created by workers – so called “unit labor costs.”
Even adjusted for productivity, however, unit labor costs have picked up from zero in 2004 to close to 3% annual growth through the third quarter of 2006, and based on other wage data, are probably advancing well above that level at present. While that might not seem like a major change, think of it this way: Suppose that a company pays 50% of its revenues out as labor compensation, and has a 10% profit margin after other costs. Holding output constant for simplicity (so that a rise in wages is also a rise in unit labor costs), a 2% increase in wage compensation (to 51% of revenues) will trigger a 10% reduction in the profit margin (to 9%). Clearly, wage shifts can have a great deal of leverage on profit margins, particularly when they are rising faster than general prices, as is presently the case.
Given the very low level of labor compensation as a fraction of GDP, coupled with a relatively low unemployment rate, it's likely that we'll continue to observe upward pressure on unit labor costs. Again, this is a threat to profit margins. The chart below shows the general relationship between labor costs and profits in data from 1990 through the third quarter of 2006. Inflation in unit labor costs is plotted along the left scale (inverted, so a declining blue line means higher wage inflation). Profit growth is depicted by the green line, measured along the right scale.
Looking closely, you'll notice something very unusual about the past year. With unit labor costs already on the rise, we've actually observed strong growth in profits anyway. As it turns out, such divergences have historically been dangerous. When we've observed such gaps in the past, they have almost invariably been closed by earnings moving in line with labor costs, not vice versa. Given present depressed levels of labor compensation and the resulting upward wage pressures, we can expect that profit margins will become increasingly difficult to sustain in the coming quarters.
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