Why Corporate Earnings Absolutely Won't Drop 50%: A Historical Perspective

 |  Includes: DIA, QQQ, SPY
by: Skyler Greene

Corporate earnings are continually proving bears wrong. Despite melodramatic predictions about the impending end of the world, the major indexes are all trucking along just fine. The S&P 500, Dow Jones Industrial Average, and Nasdaq are all having a nice year so far.

^INX Chart
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^INX data by YCharts

Earnings are continuing their long-term uptrend.

S&P 500 Earnings Per Share Chart
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S&P 500 Earnings Per Share data by YCharts

Since predicting an economic collapse has become somewhat passe, many bears are now taking a different tack to dispute the validity of earnings. They claim that corporate earnings are in a gilded age, artificially boosted by cutting wages and stomping on the little man. Since they've reached a record percentage of GDP, the bears reason that corporate earnings could drop 50%.

Why This Isn't True

The argument that corporate profitability necessarily has to fall is incorrect. Profitability is a measure of efficiency, and over time, efficiency increases due to technological developments. Thus, it's impossible to directly compare current levels of efficiency, in the age of computers and enterprise systems like SAP (SAP), with levels of efficiency from previous decades. To illustrate, here's an analogy.

A prehistoric farmer has been growing crops on his small farm. Unfortunately, in prehistoric times, growing crops is a pretty tough job. His plants don't grow very big, and a lot of them are eaten by pests. When he finally harvests his crops, he's only able to sell them in his local area - and he only makes money off whatever crops he manages to sell before they spoil. Clearly, his operation isn't very "efficient" or "profitable."

Now fast forward a couple thousand years. Modern farms use fertilizer to make the plants grow bigger and pesticides to keep the bugs away, meaning their output per acre is much higher to begin with. Thanks to air conditioning and refrigeration, their crops don't spoil as quickly, and thanks to trucks, trains, and ships, a small grape farmer in Chile can sell his grapes to grape-thirsty consumers in countries like the United States. Clearly, the farmer's "profitability" has increased dramatically over the past thousand years. But can you look at the prehistoric farmer's level of efficiency and conclude that modern farmers will someday stop being so efficient because the 2,000-year-old farmer was inefficient? Of course not.

File:Wheat yields in developing countries 1951-2004.pngClick to enlarge
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As you can see from the chart above, the productivity gains realized in agriculture over just the past half century are astounding. Nobody in their right minds would state that this increased efficiency will ever "go away" - are we ever going to stop using irrigation and fertilizer? Only if we find something even more efficient.

The same analogy applies to corporate profits. Henry Ford's assembly line revolutionized productivity, and over the past few decades, many other developments have done the same. Take lean manufacturing principles, which have dramatically increased manufacturing efficiency and decreased inventory obsolescence. The rise of enterprise information systems like SAP help multinational companies manage operations across the globe with unprecedented levels of information. As examined in this paper by researchers at Kurdistan University, newer supply chain management and enterprise resource planning systems are enabling further profitability gains. I'd also bet that the recent wave of mobile computing advances could lead to further benefits that have yet to be fully realized - imagine the potential of not being tied to a desk, but rather being able to work anywhere, anytime, through a smartphone more powerful than today's best computers.

So while it's potential that corporate earnings growth may slow, at least until we come up with the next "revolutionary" technology, it's absolutely ludicrous to use statistics like historical profits/GDP to state that earnings will fall, because it's comparing apples to oranges. In developed countries like the United States, food is a fairly small percentage of the household budget, whereas in developing countries, it is often the biggest expenditure. Can you compare the two and say that the U.S. will have to pay more for food? No? Why not? Because developed countries and developing countries are literally worlds apart. And in a way, the pre-Internet U.S. is just as technologically different from current America as a developing country is from a developed country.

Predicting a steep drop in corporate profits is predicting that the Luddites will win and technology will be abandoned. That's just not gonna happen.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.