GDP Growth Limits Corporate Profit: Continued
Corporate Profit and Population
GDP Constrains Profit Growth
Despite the increased output of MBAs from business schools over the last fifty years, there does not seem to have been any improvement in corporate profits beyond what might be explained simply by increased population and inflation.
The last half of the 20th century was also a time of great technological progress: the development of jumbo jets, man on the moon, television, computers, the artificial heart, and many other marvels.
However, there is no indication from the graph that these inventions had any significant effect on real per capita corporate profits.
It would appear that whereas larger markets, caused by population growth, drive profits upwards, competition and limitations on total cash income (GDP) prevent profit growth beyond what might be explained by demographics and inflation.
There was no reason for price-earnings ratios in 1990 to be higher than in 1950.
Granted, the swings in profits per capita can be rather violent, such as the drop of more than fifty percent from 1978 to 1982, but there is no indication of long-term improvement in the growth rate and therefore no justification for higher price-earnings ratios in the 1990s than in the 1950s.
We do know, however, that over this forty-four year period, the number of equity investors grew much faster than the population.
A severe shortage of equities was created by mass marketing of stock mutual funds.
It was this shortage, rather than improvements in the fundamentals of investment, that drove stock prices to extreme levels.
Dividend Trends and Payouts
Although per capita before-tax profits, in real terms, fluctuated around a level trend line during the last half of the 20th century, dividends measure on the same scale improved significantly, increasing, on the average, 2.8% per year.
The green line in the above graph shows how real per capita dividends almost tripled during the period. Part of the reason for this, undoubtedly, was the decrease in corporate income taxes over the period.
During the 1950s, dividend yields were not only higher than bond yields, but there were ample profit margins to protect dividends. Over the years, corporations distributed an ever-greater share of profits, reinvesting less and less.
The red line on the graph shows the percentage of profits that were distributed as dividends. Because of the reduction of corporate income taxes, we might expect dividend payouts (as compared to before-tax profits) to have increased by about 20%.
For example, payouts of around 25% in the 1950s might have risen to about 30% by the end of the century. Instead, dividend payout ratios increased much faster, eventually exceeding two-thirds of before-tax profits.
Starting in the 1980s, dividends increased much faster than earnings. To some degree, these increased dividends justified higher stock prices.
However, increasing dividend payout ratios is an unsustainable trend, limited by total profits, and, in any case, a reluctance of corporate management to invest in the future is not favorable to long-term investors.
Increasing dividend payout ratios is an unsustainable trend.
Furthermore, increasing the payout ratio, lowers coverage for dividends and this should reduce, not raise price-earnings ratios.
On several occasions during the last fifty years, profits grew faster than inflation and the population. However, these favorable times were always followed by four or five years of falling earnings, reestablishing the long-term level trend.
The graph has implications for conservative investors:
- Population growth and inflation seem to have been the main forces that have driven profits of American corporations upwards over the last half of the twentieth century.
- Technology and invention may benefit earnings of certain companies or industries from time to time, but the equity market as a whole is influenced primarily by demographics and the changing value of money.
- A long-term real increase in dividends may indicate higher payout ratios without correspondingly higher profits.
Over the last half of the century, corporate earnings, deflated, had doubled. However, the number of Americans had also increased in like fashion and the number of shareholders had expanded ten-fold, with over seventy million people now seeking to 'Own a Share in America'.
Furthermore, the market was now global with millions of foreign investors sending orders to Wall Street, putting even greater population pressure on American stock prices.
Buybacks and Broken Cycles
The classical explanation for stock market cycles is that corporations raise capital when the cost of equity is low and stop doing so when costs are high.
According to this model, a decline in the cost of capital should result in an increase in stock issues:
As more new stock is sold, prices drop. When prices fall, dividend yields increase, attracting investors.
As more investors come to the market, boosting prices, the cost of capital again falls until issuers return to sell equities, driving prices down once more.
This is a typical clockwork-cyclical explanation, consistent with the notion that market players behave rationally.
The concept of business cycles has been popular since the nineteenth century. Cycles have been variously attributed to sunspots (William Jevons), psychological trends (Arthur Pigou), under-consumption (John Hobson), innovation (Joseph Schumpeter), over-investment (Frederick von Hayek and Ludwig von Mises), and interest rates (Sir Ralph George Hawtrey). Nikolai Kondratieff thought he detected fifty-year waves of unexplained origin.
However, although markets rise and fall, no one has been able to show how to predict business cycles with confidence.
Like the canals on Mars, economic cycles are in the eye of the beholder. We can explain a specific boom or recession; but we cannot find the gears that make economic conditions repeat endlessly.
Without repetition, there are no cycles – only sequences of similar events or random change.
Executives Spurn Capital Costs
Price-earnings ratios are a rough indicator of the cost of capital.
The price-earnings ratios used in the graph, below, were calculated by dividing the market value of the equity accounts in the flow of funds table for nonfarm, nonfinancial corporations (F.102) by the net after-tax income of these corporations.
The blue line shows that over a half-century, the trend in price-earnings ratios has been upward and the cost of capital has been falling.
Until the 1970s, the graph shows that U.S. stock prices were following the traditional pattern, with price earnings ratios swinging between ten and twenty, displaying an expected cyclical pattern.
We can measure the tendency of issuers to raise equity on the market by comparing the ratio of net new issues (or buybacks) to equity outstanding.
Based on Federal Reserve flow of funds tables F.102 and L.102, the red line on the graph shows this ratio. Buybacks are indicated as the red line dips below zero on the right axis.
The red line on the graph shows that U.S. issuers have had a decreasing interest in using the capital market to raise funds.
In 1955, corporations, on balance, were issuing new stock equivalent to about one percent of the market capitalization of outstanding issues.
By 1985, net new issues had disappeared and net buybacks amounted to about five percent of market capitalization.
The lines on the graph move in the opposite direction suggested by economic theory and supposedly rational behavior of corporations.
As capital became cheaper, corporations had less interest in raising equity.
As capital became cheaper (i.e., as price-earnings ratios increased), corporations had less interest in raising equity (i.e., new issues as a percent of equity declined and even turned negative).
In the early 1950s, the typical price-earnings ratio was ten, while net new issues averaged about 1.5% of market capitalization.
Over the next decade, price-earnings ratios doubled (i.e., the cost of capital halved), while new issues fell to zero. By the 1980s, corporations were intent on using buybacks to drive up equity prices and did not take advantage of low capital costs to raise money.
The Fifty-Year View
There is no pattern of cyclical reversions driven by cost of capital. Instead, we see a slow change in the way the capital market works. Perhaps the most interesting thing is the half-century period that we must examine to see the trend.
Quarterly, annual, and even five-year trends, common in the financial press, provide too limited a perspective to reveal the evolution of capital markets. In our graph, although the lines have wandered around the trend, there is no indication of a cycle, unless it be some super-Kondratieff wave welling up to sweep us all away.
Certainly the classical economic cost-of-capital cycle that is said to drive equity markets does not seem to be working for U.S. issuers.
The mass marketing of common stock to an increasingly unsophisticated public, without concern that the future supply of equity might be insufficient to meet the needs of these investors, and the use of stock buybacks to inflate share prices, raises concern as to the future of the U.S. capital market and the nation.
July 25, 2020
Essay: End
