John Hussman on The Coming Retreat in Corporate Earnings
There are several ways to look at profit margins, with varying implications – though all negative – for the extent of retrenchment that can be expected in corporate earnings in the coming 2-4 year period. The first chart below presents a rather pure mean-reversion argument. The blue line shows the ratio of corporate profits to GDP, which is currently more than 80% above its historical norm. The red line shows the annual growth in profits over the following4-year period (inverted). Put simply, high profits/GDP are associated with weak subsequent profit growth, while depressed profits/GDP are associated with strong subsequent profit growth. At present, the extreme profit/GDP ratio we observe here is consistent with expectations of a 22% annual contraction in profits over the coming 4-year period – which would imply a roughly 63% cumulative contraction in profits from present levels. My impression is that’s probably too aggressive an expectation except as a temporary trough. A more reasonable expectation, in my view, would put corporate profits down about 10% annually over the next few years.
Part of the reason we would expect a more muted contraction in profit margins is the recognition that government budget deficits are likely to remain relatively high in the coming years. A simple way to think of the circular flow of the economy is that corporations produce output and pay salaries, while worker/households use that income to purchase output and consume. In recent years, weak employment paired with massive government deficits have introduced a wedge into the circular flow, allowing wages and salaries to fall to the lowest share of GDP in history, even while households have been able to maintain consumption as the result of deficit spending, reduced household savings, unemployment compensation and the like.
The deficits of one sector emerge as the surplus of another. As a result, deep deficits in combined government and household saving have created a mirror-image surplus of corporate profits in recent years. The chart below shows the relationship between 3-year changes in government and household savings versus 3-year growth in corporate profits (partly overlapping, but partly subsequent as inventories and other factors can induce slight lags). The upshot of this chart is that recent improvements in government and household savings are already working their way through the economy, and are likely to be observed as a contraction of corporate profits in the next few years.