A Funny Thing Happened on the Way to Equilibrium – GMO Quarterly Letter 04-26-13

Salient to Investors:

Ben Inker writes:

Capitalism should cause the return on capital to be in line with the cost of capital, and assets with similar risks should offer similar long-term returns. Equities should trade at replacement cost, and the long-term return to equities should be approximately the same as their normalized earnings yield. Assets without long return histories should have similar valuations and equilibrium returns as related assets with longer histories.

US companies’ persistently high profit margins is a concern because they should not persist in a mean-reverting world. Yet profitability in the US has been higher than long-term averages for most of the past 20 years, about the same time that the US market has been trading above replacement cost.

Most other stock markets around the world also show elevated profit margins. Global profits are almost certainly near all-time highs as a percent of global GDP.

It does not seem prudent to assume a non-equilibrium situation will persist indefinitely. There are ways for profits to stay high indefinitely, but society may not be willing to put up with them.

Today’s profitability makes perfect sense in the current economy.

The Kalecki equation states: Profits = Investment +Dividends – Household Savings – Government Savings – Foreign Savings

Up until 1987, there was a correlation of 0.75 between investment and profits. But from 1987-99, there was a marked deterioration in the correlation, and since 2000 it has been -0.48. The Kalecki equation states that, all else equal, lower investment should lead to lower profitability, so since 1987 all else has not been equal and very few things have been equal since 2000.

The last few years of the 1990s saw the extraordinary wealth transfer in the form of stock options on tech companies. From a national income account perspective, money that employees received from the exercise of stock options is counted as a cost to corporations, and therefore to shareholders who wound up giving away untold billions to the option holders.

Since 2000, investment has fallen to the lowest levels ever seen, apart from the Great Depression, while profitability has risen to an all-time peak. This was possible because the sum of household and government savings as a percent of GDP has fallen to -5%, versus the average of 3-7% of GDP excluding the Great Depression and late WWII.  Relative to the last 60 years, household and government savings were responsible for profits being 10% of GDP higher than they would otherwise be – so virtually accounting for all corporate profitability since the financial crisis.

The fall-off in investment has really been just since the financial crisis. Profits are just off their all-time high relative to GDP, but companies are investing less than at any point since the Great Depression. Andrew Smithers of Smithers & Co. says this unwillingness to invest is a symptom of the “bonus culture” in which CEOs who realize their tenure may be short, focus on activities that boost stock prices up in the short-term so they can get rich quickly, and ignore the long run as it is unlikely to come about on their watch.

The predominant stores of wealth for the middle class are home equity and savings in the bank, while dividends accrue overwhelmingly to the rich, who have been doing very well in the past 30 years.

Social mobility in the US is increasingly being proved to be a myth.  Rising savings, all else equal, hurts profits. Negative savings rates for the bulk of households in the 1990s were the result of people spending on the assumption that the stock market would always go up, and in the 2000s on the assumption that home prices would always go up.

Read the full article at  http://www.gmo.com/websitecontent/GMO_QtlyLetter_1Q2013.pdf

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