Tuesday, June 16, 2009

Where Are Profits Going?

This blog's position has always been that the US economy's performance post-2000 has been due to ever-increasing assumption of debt, particularly by households to finance real estate purchases and personal consumption. I don't think anyone can dispute this any more: just look at the chart below (click to enlarge).

The Debt Boom Finally Begat The Bust
Charts: FRB St. Louis

Debt kept accelerating while GDP remained "stuck" at around 5% annually (these are nominal figures). In the end, the debt boom created its own bust and dragged down the entire economy. Cement shoes come to mind...

So, now what? What does the future hold? In particular, I am referring to corporate profits, the fundamental driver of stock market performance. We can analyse markets using a multitude of perspectives from astrological to psychological but, when it's all said and done, what matters is profits.

Since 1997, or so, households assumed ever more debt in order to consume and, thus, increase corporate profits. At the top in 2006 it took an additional $1.3 trillion in household debt to generate an additional $300 billion in profits, i.e. a ratio of 4.3 times (see chart below). The debt intensity of corporate profitability was huge, but it weren't corporations themselves that were going into debt; it was their customers.

Annual Increases In Household Debt and Corporate Profits ($ Billion)

We are now deep in a debt-bust crisis and it is the first time since at least 1953 that household debt is decreasing in absolute numbers, year on year. What does this mean for corporate profits? Based on the relationship above, I expect they have quite a bit more to drop, perhaps after a (very) brief period of stabilization due to cost cutting (see chart below).

Corporate Profits After Tax

I would thus not be at all surprised to see after-tax profits go back to around $300 billion/year, where they were in 1992 at the beginning of the debt acceleration cycle. What does this mean for stocks? Look at the chart of S&P 500 below (click to enlarge).

S&P 500 Share Index

In 1992 S&P 500 was around 400, or 57% lower than current levels. Of course, this is a pretty simplistic and one-faceted approach to corporate profits and the market, dealing as it does only with debt. (But then again... KISS has always been pretty good guidance.)

There is another macro approach to corporate profits, however. As a share of GDP pre-tax profits had reached a record 13% in 2006: corporate greed had reached a peak, indeed.

Data: FRB St. Louis

If the ratio of profits declines to a new low, say 5%, and nominal GDP declines another 10% to $12.6 trillion (not at all impossible in this crisis, it was there at the end of 2005), then we are looking at pre-tax corporate profits of around $630 billion.

Now, include a boost in tax rates from the Obama administration and the $300 billion after-tax number mentioned above does not look so outlandish, all of a sudden.


  1. in my opinion, one of your best posts since I read your blog (almost 2 years).
    The charts and commentary are great.

    I did not even know those StLouisFed.org charts on corporate profits.
    And I am shocked to see that corporate profits are still a two times higher than at the peak of the Internet bubble in 2000.
    How can this be?
    I thought the S&P 500 profits were down to pretty much zero...

    If the profits are still that high after the credit crunch, credit market collapse, housing market collapse etc, what will bring them down?!
    I understand your take, that the debt will have to be serviced, etc.
    Though, as long as people finance the US Govt debt who itself support whoever has problem borrowing, nobody goes bankrupt and the system goes on with devalued dollars which boosts profits...

  2. Another Excellent post! Form a technical analysis viewpoint I have also eyed the 350-400 area as the bear market low for the S&P500 index. My reason is that all bubbles eventually tend to return to the point from where they began to inflate, hence those levels.

    There are some who claim the Dow Jones Index really is at around 100,000 if you consider reinvested dividends throughout time. When in fact it wouldn't be the index that is at 100k but an investment portfolio and it's value derives from share prices which are pointing south, so in essence the reinvested dividend thesis is mere spin from the permagrowth cheerleaders. I have a feeling for the same reasons expressed in your post that dividends going forward will be sparse.

  3. According to ShadowStats, we have been at -GDP since the dot.com bust. So yes, this whole so-called economy was a debt based illusion.

    The suffering has only begun. According to a recent Bloomberg report, for every 5 unemployed people there is one available job.

    Sounds like a lot of permanently out of work people. As Kunstler is fond of saying, we need to make other arrangements.

    Joe M.

  4. When you consider that since at least Louis XV, if not before, THEY have been building machines to put people out of work, that machines are made to put people out of work, then the handwriting has been on the wall for ALL to see for quite some time now.
    So, are we surprised ? Hardly...
    Old adage which is as true now as it always has been :
    What goes around comes around.

  5. http://www.truthdig.com/report/item/20090614_the_american_empire_is_bankrupt/

    Loss of USD as world reserve currency is at hand. This was so obvious I cannot believe more people did not see it coming.

    Joe M.

  6. Sorry about the truncated link. Just go to truthdig.com and read "The American Empire is Bankrupt".

  7. I think you're talking about a reversal of the "P/E multiple expansion" we've witnessed in the markets since the 1980's. Am I incorrect? "How much would you be willing to pay, Sir/Madam, for a dollar of future profits?".
    It seems likely, given the depth and extent of the damage done, and yet to come. Such a multiples compression will probably have quite an effect on the public's trust in stocks and asset backed methods of wealth generation and storage. maybe we're heading back to the ATT 'widows and orphans' style of public stock participation, where only dividends matter. of course, most dividends would have to take quite a beating on the way to that end, as corporations struggled to protect their balance sheets.

    unregulated, laissez-faire, speculative capitalism....it's fantastic!!!

  8. To : Anon.

    I am talking about three things possibly happening all at once:

    1. Lower profits
    2. Lower GDP
    3. Higher corporate tax rates.

    I think it is only logical that P/Es will come down sharply under such an outcome.


  9. Great post Hell, much appreciated.

    The only guesstimate I would disagree with is higher Corporate taxes--unless you consider carbon taxes. The push on the upper and upper-middle classes in the form of extended "payroll" and capital gains taxes is a more likely scenario.

  10. Great post...! One of the best I've seen... I guess that the don't say a picture is worth a thousand words, for nothing... :-)

    I concur wholeheartedly with your post...

    The times, they are a changing. We seem to be caught in an insolvency trap with no means of escape. So much for American ingenuity....

    Best regards,


  11. Heard a great comment this morning on MY public radio, and I thought that YOU, Hell, as a person interested in MOVEABLE CONTAINERS in all shapes and sizes would be interested...
    It seems that the Somalian pirates (I can hear y'all just now, PIRACY IS BAD, PIRACY IS A SIN...), have been taking their profits and investing in infrastructure, and trying to get INVESTORS into their country (well, at least until the Mafia got into the game...)
    Ah, the joys of capitalism...
    And apparently British Airlines has suggested to its employees that they ought to discover the joys of working (for their company...) for freen in order to save their jobs...
    Well, why not ? But I hope that their working conditions MOTIVATE them to want to work for free...

  12. does anyone know where to get data to assess US corporations aggregated balance sheet?

  13. I think you make a big confusion : yes national corporate profits will have difficulties to revover without leverage taken by customers. however, looking at the SP 500, 40 % of profits are made outeside of the US. so the question for the SP 500 is not to know if US consumers will recover; the question is : are foreigners going to save US corporate profits and the SP 500 ! So the answer to this question is where is going the USD. Obviously the US adminstration will push it down and the SP 500 will rise !

  14. Re: 40 % of profits outside the US

    Without doing the research I am nevertheless pretty sure this percentage is largely due to a) US based international oil cos. like Exxon and b) financials.

    I don't know about oil, but financials are already in a deep slump and won't be coming out soon.



  15. FYI, and slightly drifting from the main subject of the original Post from Hellasious...

    I would like to modelize the world's main economic blocks balance sheets.

    By economic blocks, I mean:
    - US/EU/JP/China/etc households
    - US/EU/JP/China/etc corporations
    - US/EU/JP/China/etc governments

    The objective is to have the big picture on who are the biggest economic actors? who is overleveraged? and potential consequences?
    Here is my input so far:

    Thanks to anybody who can help.

  16. Yup, I can agree with that. However, as usual the smaller fish get hit the hardest, because they don't have that much lobbying power and therefore can't make the new rules. Some will go under, some will be gobbled up using some kind of crystal-clear Bailout funds, and in the end does profit really matter when you're too big to fail, get to grab from federal budget and get a nice salary.
    Ah, that and now the average bold fool won't have so much success being the 'successful businessman', too.

  17. Persian Empire was a great secular nation until radical religious retards turn the middle east in Muslim and Jewish states.

    People that believe in Angels, Hell, intelligent design, A boat with all the world's animal species on it, the earth on the back of a turtle, ect.. are INSANE!

    Religion is the ROOT of ALL EVIL.

    Christian radical religious retards are the greatest threat in America today. By FAR

    Human beings have the potential to be brain washed and religion is how it is done - the desire for safety and security is what opens the door for this crap.

    Muslims, Jews, Chritians = ROOT OF ALL EVIL IN THE WORLD.

    Let us hope the young people in Iran can turn it back into a secular state and so then expose Isreal as the rascist Jewish state that it also is.

  18. Keep up the nice work.

    I call our fiscal and monetary response to this crisis the great experiment. I fail to visualize how this works. The road seems to end in devaluation.

  19. I've finally gotten around to reading Minsky's _Stabilizing an Unstable Economy_ (1986 mind you).

    Towards the beginning of chapter 7 he sets up some equations representing prices, quantities, wages and employment (P, Q, W and N with various subscripts).

    It should go without saying that P, Q, W and N imply other values.

    He then goes through a short series of transformations and ends up with an equation expressing profits and then explains the equation with the following words:

    "As the wage bill in investment goods is the profits in consumer goods, simple arithmetic and extreme behavioral assumptions lead to the strong proposition that profits equal investments."

    Whoa - profits = investment.

    For the sake of argument let's assume that's true. It seem to me to imply two things.

    1. With a lag of course, no investment = no profits. In a somewhat idealized sense ("extreme behavioral assumptions") but still with probably considerable real-world implications.

    2. longer-term as regards financial capitalism in general. Investments = profits. That's what puts us on the hamster wheel of eternal 'progress' under capitalism. You have to continue to keep growing (investing) otherwise the system breaks down (no profits).