Some economic data gets lost in the clutter of the constant news flow barraging investors. Yes, the payroll report and certain other data are widely studied, but other data are not. For example, consider the data the Bureau of Labor Statistics released June 7 on productivity and unit labor costs. These data, while perhaps obscure, have direct relevance to U.S. equity markets. How? Let's go through the process of examining the relationship between the markets and these reports.
The intuitive role of corporate profits on the market
The first step is establishing the (perhaps rather obvious) relationship between corporate profits and the market. They don't move exactly in tandem over the short run, but over time, they are related. And in periods where the market has gotten ahead of profits (think the tech bubble at the beginning of the millennium), a bear market then ensued.
Of course, there are many factors besides corporate profits that go into determining market prices, and forecasting the market is fraught with difficulty. But we can examine the underlying variables to get a sense of some of the risks to the market. Let's look at the relationship between corporate profits (using data for a measure that is after-tax and without certain adjustments published by the Bureau of Economic Analysis) and the Nasdaq Composite, provided by the St. Louis Federal Reserve. (Since the measure of corporate profits is for all companies, large and small, public and private, the Nasdaq provides a better representation than a large-cap stock index like the S&P 500.) Note that this shows the general relationship, but does not indicate an actual fair value.
How productivity gains enhance profits
Having established a relationship between profits and the market, let's consider the productivity and unit labor costs report released June 7. It's a fairly basic and intuitive relationship: when productivity is high and unit labor costs are low, corporate profits tend to be stronger. Productivity allows a company to produce more with the same number of labor hours, so when productivity is weak, profits take a hit, partly because unit labor costs rise.
Consider the past two quarters. Productivity declined by 0.6% at an annual rate in the first quarter, following a 1.7% drop in the fourth quarter according to the BLS. In tandem, profits declined by 3.6% in the first quarter from a year ago, following a similar drop in the fourth quarter, according to the BEA.
Now let's look at the relationship between productivity and corporate profits. Note the tight correlation in data going back to 1947.
Labor costs are inversely related to profits
The reverse holds true for unit labor costs, where you'll see a direct, inverse relationship between unit labor costs and corporate profits, going back to 1947. This matters for a few reasons. One is that, as productivity falls, unit labor costs rise, because each worker is producing fewer "units" (which could be haircuts or toasters, etc.) per hour, even if their hourly compensation doesn't change.
Unit labor costs jumped 4.5% in the first quarter, following a 5.4% increase in the fourth quarter. Here's how the dynamics of productivity affect a company's costs: Companies increased hourly compensation by 3.9%, but the output per hour fell by 0.6%. Thus, companies' labor costs rose faster than wages did, because productivity fell.
At this point, it's important to remember that productivity gains are hard to influence, because it is usually through the introduction of new technologies, equipment or processes. It's not a worker producing ever more toasters on an assembly line or a barber cutting hair twice as fast. It's a puzzle to academics, economists and stock analysts. But whatever the reason, it does influence profits -- and profits are an instrumental force in guiding the market higher or lower, over the long run.
Are markets today expensive compared to profits?
In that vein, we get to the final takeaway, the relationship between market prices and profits. In the graph below, we can see a very rough (and admittedly, simplistic) measure that illustrates the long-term relationship between one measure of the market and corporate profits. Here, we see that the Nasdaq index is perhaps rather expensive compared to economy-wide profits.
Of course, more in-depth research is required to determine a fair level for the market, and one graph is not a reason to buy or sell. Still, it reminds investors of the role that central bank policy has played in driving asset prices higher, perhaps beyond what profits might suggest. The question is, what risks to the outlook might seemingly obscure economic indicators suggest?
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