Essay: Correlation between Population and Corporate Profits
Corporate Profits and Population
I would rather sit on a pumpkin and have it all to myself than be crowded on a velvet cushion
If there are sound reasons to believe that corporate profits will forever grow faster than the discount rate of a rational investor, some might, with apparent merit, argue that the present value of the future stream of dividends is infinite.
This mathematical oddity – the Petersburg Paradox – justifies almost any level of stock prices, as long as one expects dividends to continue to increase faster than investors' target rate of return.
Praising the Virtuous Circle
During the Great Bubble, when price-earnings ratios reached thirty and above, some said that prices were not excessive because investors benefited from technological innovation, productivity gains, expanding profits, skillful management, and a wise government that avoided inflation, unemployment, and excessive taxation.
During the 1990s, many thought that the United States had entered a time of lasting growth spurred by information technology and globalization.
President Clinton and Federal Reserve Chairman Greenspan spoke confidently of a Virtuous Cycle of sound investment strategies, high employment, increasing productivity, and low inflation.
Official statistics supported claims of enlightened economic management.
New Eras and Paradigm Shifts
New Era theories had been advanced in the 1920s to explain high stock prices before the Crash of 1929, although average price-earnings ratios only reached twenty at the market peak.
However, events showed that the bull market of the 1920s was driven by investors speculating on credit, not by justifiable expectations of a brighter future.
We should just as critically examine New Age claims of the 1990s.
New Age arguments induced many to invest in stocks – even at thirty times earnings.
Could New Age progress explain why earnings multiples of thirty were now warranted, replacing customary multiples of fifteen that had been the rule for over one hundred years?
Although it may appear that prices were rising because companies were taking shares off the market with buybacks, rather than because of increased intrinsic value, we should not dismiss, out of hand, the possibility of a real economic 'paradigm shift'.
Some claims of progress were true, although misleading or irrelevant.
- Corporate profits had indeed been increasing.
- Government statistics did show productivity to be improving.
- Inflation appeared to be under control.
- Rapid development of computers, the Internet, information technology, medical procedures, and telecommunication were manifest indications of technological progress.
High price-earnings ratios might be justified if corporate growth was likely to be so rapid as to assure that increasing cash dividends would soon surpass bond coupons and would continue to grow indefinitely at a fast rate.
The question is not whether there were signs of advancement, which clearly was the case, but whether these indicators had anything to do with the supposed expanded investment merit of equities.
Was the outlook for corporate profits in 1999 any better than in 1950 or 1860?
Buying Stocks Through Mutual Funds
Seventy million Americans did not come to own stock without some persuasion. The most effective promoters were open-end mutual fund salesmen.
Wall Street began to mass-market mutual funds in the early 1950s.
- During the 1950s and 1960s, mutual funds were sold door-to-door through periodic savings plans.
- Investors agreed to send monthly installments to the fund administrator, and sales charges for a five or ten-year plan were deducted from first-year payments.
- At least half of initial payments went to cover selling costs. The commission scheme, similar to that of life insurance, was sufficiently rich to support the unparalleled, highly effective promotion of stocks to millions of households.
During the fifties, funds were bought by ordinary people as a way to save for retirement and for education of children. Investors who kept up payments could reasonably expect returns that surpassed bonds.
Disciplined savings and dollar-cost-averaging were arguments for planned, long-term systematic investment.
In those days, dividends less management fees still produced higher cash yields than bonds.
Funds were touted as a way to manage risk through diversification, while lowering costs through wholesale commission rates.
In the 1950s, high dividends and diversification made mutual funds a conservative investment.
The Industrial Power Pitch
American industrial power was a common marketing pitch, as this excerpt from a mutual fund sales course in the fifties shows:
Doubting Client : But how will I know that the stocks held in the fund will continue to be valuable?
Adroit Salesman :(Taking the client to the window of his office and pointing to the industrial landscape) Mr. Big, do you see those smokestacks on the horizon? As long as you see smoke coming from the chimneys of American industry, you will know that your investments are safe!
Today this argument is outmoded and environmentally quaint.
However, in the 1950s, the recent victory in World War II and long history of industrial pre-eminence of the United States since the late nineteenth century, justified the widely held belief that American industrial equities were the soundest of investments.
Those who owned a portfolio of industrial stocks with tangible net worth and high cash dividends had reasons for confidence.
- Europe was still digging from the rubble of World War II and 'Made in Japan' still connoted inferior quality.
- The Brazilian Economic Miracle and the Asian Tigers were one and two generations in the future.
The United States was a great industrial power and Americans had faith in the future.
- Most people lived in cities that had at least one or two industrial corporations of international prestige and dominance.
- Many American companies led the world in quality.
- The parking lots of factories overflowed with workers’ cars – a popular indicator of wealth and proof of the superiority of American democratic capitalism.
The slogan, 'Own a Share of America' exerted a strong emotional response, with a patriotic pull on investors’ wallets.
Mutual fund savers of the 1960s belonged to the lucky generation
Furthermore, a prudent forty-year-old mutual fund saver of the 1960s would have been able to retire comfortably in the 1980s and 1990s, liquidating his or her funds into one of the great bull markets of all time.
This was the lucky generation, since, for them, the Common Stock Legend proved to be true.
It was natural that their children would follow their example, trusting implicitly in the managers of equity mutual funds.
From Smokestacks to Statistics
However, by the 1990s Americans no longer could corroborate national economic progress by checking labels of national origin and the quality of merchandise at Sears Roebuck or Macy’s.
A stockholder could no longer look out the windows to see smoke coming from the chimneys of American industry to judge whether the economy was progressing.
Astounding quantities of goods, from clothes to computers to appliances, were now made abroad.
To be aware of U.S. economic progress, Americans could only rely on government data.
Although some understood government statistics, most did not.
The press and the public uncritically accepted favorable reports of productivity or increasing Gross National Product, even though relatively few knew how the data was put together.
Investors followed the calendar for the release of official statistics that would trigger rising and falling equity prices.
Shareholders relied on government statistics, interpreted by proponents of bull markets, and on noisy urgings of TV promoters that had commercial reasons to bend the truth.
As long as one had a job and a portfolio that seemed to be growing, the unsophisticated investor had scant basis for negative thoughts.
Expectations of Growth
During the 1990s, the flow of fund accounts for nonfarm, nonfinancial corporations (F.102) showed corporate after-tax profits growing at an annual rate of 10.1%, compared with 7.8% growth in earnings over the preceding thirty-seven years from 1952 to 1989.
Many expected that New Age rates of profit growth would continue well into the new millennium, thereby justifying higher price-earnings ratios for stocks.
Their explanation for continued and improved profit growth was that, thanks to advances in management science, corporate executives now knew how to create earnings faster than their forefathers.
Many thought that executives knew how to expand earnings faster than their forefathers.
If scientists at the Massachusetts Institute of Technology could come up with new discoveries that pushed forward technology, was it not reasonable to expect the same from the doctors of economic science, just up the Charles River at the Harvard Business School?
If the Public Broadcasting System, a government sponsored media outlet, was claiming that the Black-Scholes formula was the business equivalent of the discovery of DNA — an advance so significant that it would forever alter the world of finance — would it not seem plausible in the popular mind that 'economic science' had indeed squared the circle and found ways to permanently increase profit growth?
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