Ratio of Corporate Profits-to-GDP and Returns (1947 to Present)
Source: Hussman Weekly Comment “Taking Distortion at Face Value,” (April 8, 2013)
Warren Buffett, 1999
[F]rom 1951 on, the percentage settled down pretty much to a 4% to 6.5% range.
…
In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well.
— Warren Buffett, Mr. Buffett on the Stock Market (November 1999)
Jeremy Grantham, 2006
Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.
— Jeremy Grantham, Barron’s (c. 2006), via Katsenelson, The Little Book of Sideways Markets.
John Hussman, 2013
In general, elevated profit margins are associated with weak profit growth over the following 4-year period. The historical norm for corporate profits is about 6% of GDP. The present level is about 70% above that, and can be expected to be followed by a contraction in corporate profits over the coming 4-year period, at a roughly 12% annual rate. This will be a surprise. It should not be a surprise.
— John Hussman, Two Myths and a Legend (March 11, 2013)
h/t Butler|Philbrick|Gordillo and Associates
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[…] profit margins have important implications for valuation and future expected returns. Why? Jeremy Grantham, co-founder of Boston-based asset manager GMO, put it best, “Profit margins are probably the most […]
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Don’t forget that GDP can be calculated as the sum of all earnings or the sum of all expenditures. Whether GDP grows from foreign earnings or domestic earnings doesn’t matter – peoples expenditure in the US will still rise and fall (and with it GDP) from the total earnings of the economy. As such, GDP already reflects most of the foreign earnings of corporates quite well.
To see this, just substitute GNP for GDP and you’ll find it doesn’t affect the conclusions of hussman’s report at all. In fact Hussman has covered this in his weekly posts already. It’s a red herring.
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If you look at the chart from Hussman, it shows very clearly that the relationship between corporate profts to GDP and future growth has been constant throughout the period. Foreign profits grew throughout this period and had no effect on the relationship. It is entirely disengenuous to suggest it will all of a sudden start having an effect now.
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Agreed.
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The reversion of profits/GDP is primarily driven by a reversion to mean of profit margins, no revenues. It is extremely unlikely that the source of profits has any material impact on the volatility of margins, though, conceivably, it might be able to effect the mean. I too would like to see a more thorough treatment of this issue.
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Raj took a look at it here:Profiting From Foreign Profits: Are Corporate Profit Margins Abnormally Elevated Or Sustainable?
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[…] Warren Buffett, Jeremy Grantham, and John Hussman on Profit, GDP and Competition (greenbackd.com) […]
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[…] Today’s equity markets are undergoing this very process. Since 2009 all manner of worries have been leveled against the US market including the implosion of the Euro. To be sure there are still some legitimate concerns with today’s market including high valuations and much higher than normal corporate profit margins. […]
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[…] What Record Corporate Profit Margins Imply For Future Profitability and The Stock Market, Warren Buffett, Jeremy Grantham, and John Hussman on Profit, GDP and Competition). Those posts sparked some intense debate in the comments and offline about the increasing […]
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[…] Warren Buffett, Jeremy Grantham, and John Hussman on Profit, GDP and Competition (greenbackd.com) […]
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[…] above the historical mean going back to 1947, as I’ve discussed earlier (see, for example, Warren Buffett, Jeremy Grantham, and John Hussman on Profit, GDP and Competition). John Hussman attributes it to the record negative low in combined household and government […]
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Hi Jeff S., I’ve been avidly following this topic and would love to see the charts you’ve put together, if you don’t mind emailing them to me (ryerasi@gmail.com). I tried crunching some numbers myself a couple months ago and found NIPA data that represents profits from just domestic industries, which excludes foreign earnings and therefore should be the right analogue to GDP. Based on that, it looked to me like corporate profits are elevated at a current level of around 8% of GDP, which is what they were in 2005 & 2006, the height of the credit bubble. Over the last 3 decades, the average level was 4.7%.
Of course, this is based on gov’t statistics, which could be flawed, and perhaps there are other factors at play that could make these profit levels more sustainable…
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Raj, I would be happy to take a look at your data too, and/or run it as a guest post if you’re inclined to write it up.
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Raj, I believe I looked at the same data you did. That was my starting point. The problem is, NIPA domestic profits don’t represent the correct domestic profits number. Let me explain. The NIPAs include tabulations for both total corporate profits and domestic profits. NIPA total corporate profits are closer in concept to GAAP and S&P 500, because like GAAP, they are the global profits of U.S.-headquartered companies only. In contrast, domestic profits are profits earned from U.S. operations regardless of where the company is headquartered. So what I had to do was come up with the correct foreign profits number, and then back into the domestic number by subtracting foreign from total. I will email you my charts, along with an article from the BEA that discusses NIPA profits so you can understand how I came up with the adjustments.
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A link to the BEA report to which Jeff and Raj refer: Comparing NIPA Profits With S&P 500 Profits (.pdf) by Andrew W. Hodge (March 2011).
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[…] Beware of profit margin REVERSION TO THE MEAN! https://greenbackd.com/2013/04/19/jeremy-grantham-profit-margins-are-probably-the-most-mean-reverting… […]
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Jeff — Why won’t foreign profits also not be prone to the same pressures as domestic profits? Why wouldn’t competition abroard, as it would domestically, act a natural brake on an ever-expanding share of global profits of the S & P 500? Yes, many countries are growing faster than the US, hence you could say that even a decreasing share of an expanding pie would still make profits as a share of US GDP hold at current levels, but :1) it never is different; 2) Foreign countries have very uneven growth profiles & 3) Their institutional underpinnings are very poor compared to the US, hence more difficult to make money even if they overall pie is growing.
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You seem to be mixing up net profit margins and corporate profits to GDP. If U.S. businesses continue to expand internationally, continue to build factories overseas, continue to generate revenue and profits abroad, then foreign profits to GDP will go up as will, by necessity, total corporate profits to GDP. There is no force that is going to make those overseas factories go away. The more that are built and the more profits that are made abroad, then the corporate profits to GDP goes up. That is why I view foreign profits as more additive in nature as opposed to mean reverting.
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This is more evidence we are in an equity bubble most likely caused by Federal Reserve monetary policies. Buyers beware!
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Don’t forget the fiscal stimulus!
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Domestic profits are 6.2% of GDP. No bubble.
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Jeff,
I have some sympathy for your view, and I’m interested to see the extent to which foreign earnings may have shifted up the mean. I invited you several weeks ago to write up your ideas as a guest post. You have yet to get back to me.
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Tobias, I would consider putting together a guest post if you would double check my math. The questions are:
1. Did I calculate the correct domestic profits number
2. Did I allocate the taxes appropriately
Do you still have the email I sent you? It has both my analysis and the BEA article I used to come up with the adjustments.
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I do. I will take a look and reply to the email.
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Corporate profits to GDP are not equivalent to profit margins. Although there should be some correlations. As for corporate profits to GDP, domestic profits are currently 6.2% of GDP. That is within a reasonable range, especially given that effective tax rates have been coming down since WWII, wages to GDP have been coming down for a while, interest rates are really low, etc. So how are “total” corporate profits to GDP at 10%? Foreign earnings. They now make up 3.7% of GDP. And they are additive. There is no reason that they will go down. They will continue to grow as corporations continue to expand globally. They have gone from about 1.5% of GDP to 3.7% in the last 10 years.
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And given that foreign earnings won’t be coming down very much if at all, for the total number to get to 6%, domestic profits would have to drop to 2.3% of GDP (2.3% domestic + 3.7% foreign = 6%). That just isn’t going to happen. They haven’t been down that low since the Great Depression.
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Jeff S., thanks for the comments. I’ve long wondered whether the increasing percentage of profits U.S. companies earn abroad weakens the usefulness of the Corporate Profits/GDP number. Especially now that S&P500 companies earn about half their profits abroad.
Do you know by any chance what % of corporate profits were from foreign sources, say, thirty years ago?
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As of now, foreign profits make up about 40% of total corporate profits. 30 years ago it was around 20%. 50 years ago it was around 10%. I put together some great charts if you want me to email them to you.
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If foreign profits make up nearly 40% of total corporate profits, then for the S&P 500 in particular I wouldn’t be shocked if the number were closer to 50%.
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