Market crashes come from the variance in earnings, not from the variation in GDP. However, GDP and the business cycle often correlate with the profit cycle.
I will present a method for monitoring the cycle in domestic profits to help correlate the profit cycle with the business cycle.
Profit margins are the link between how other cycles impact the profit cycle and, thus, the overall business cycle. Understanding the factor that moves profit margins is the primary method for monitoring and defending against significant market events.
In part one of the series Anatomy of a Market Crash, we discussed valuation anchors and the long-run return. The takeaway from part one is the ability to identify periods of extremely low and extremely high valuations. The major drawback of valuation anchors is how the model breaks down when forecasting for less than 10 years. However, it does give us a base to gauge the impact of a market event such as a market crash. Ideally, to have a market crash, we need to have a wide enough move back towards the valuation anchor to be considered a market crash. You can read more about the post here: Part One
In part two of the series, we pick up where we left off from part one, tackling what takes place between the 10-year and 1-year process of a market crash.
In part one, I referenced a quote from Robert McGee, which addressed the widespread belief that the expectation of future earnings drives equity prices. Continuing that theme, we will focus on the profit cycle, which is one of the many factors that contribute to the business cycle.
The Profit Cycle
First, the profit cycle should not be confused with the business cycle. The profit cycle is a cycle that often correlates with the growth rate cycle more than the business cycle, but like most cycles, both are interrelated with differences. I define the profit cycle as the fluctuations in earnings of corporations. The growth rate cycle, on the other hand, is the growth rate of real GDP of an economy.
The real growth rate of the US economy varies from about 5% during expansion stages, and for recessions, it averages around negative 2%. Earnings, on the other hand, are much more dramatic; earnings can grow around 15-20% annually, while during recessions, it can completely collapse towards a negative 50-60% growth rate. While the long-term growth rate is about 6% for both nominal GDP and earnings, the variance in earnings growth is more dramatic.
This variance in earnings growth also explains why a stock market crash can be so dramatic. Take, for example, Earnings Per Share for the S&P 500. The increased variance was apparent when you saw EPS go from 104.83 in June 2007 to a low of 8.5 in April 2009.
Currently, the growth rate of earnings is about to turn negative in Q1 2020, indicating the market is reaching critical mass in the near term. The question remains, will this be another earnings contraction like 2016, or will it become something more dangerous such as a recession? To answer those tough questions, we have to dive deeper and understand the cyclical nature of the significant drivers of earnings.
Profit Cycle Anchor
Since I have a belief that all cycles have some measurable anchor, here is my theory on the profit cycle anchor. Real GDP is a measurement of domestic production only and excludes foreign production. However, corporations are becoming more and more dependent on foreign earnings. So to measure the cyclical nature of the profit cycle to the business cycle, and thus a possible recession, all one has do is measure the relationship between foreign and domestic net profits. We can estimate a link between foreign and internal net profits by showing foreign net earnings as a percentage of total pre-tax corporate profits.
The anchor not only provides us a way to measure national product trends but also explains why corporate profits can grow at a faster rate than the GDP. Assuming globalization continues and US corporations maintain their strong position in global commerce, it seems logical to expect that corporate profit growth will continue to exceed domestic output growth for the foreseeable future.
With the anchor moving above its long term average, we can see that corporations are relying on foreign revenue for earnings more than domestic, indicating that a possible domestic recession is in the near future.
Corporate profits are the cash flow generated by corporations that is available to pay back debt, interest expense, and other variable expenses. The profit margin is the amount of revenue that goes to pay those expenses.
When was the last time you herd a Fed Chairman mention declining margins in U.S. corporations? The overlooked profit margins are critical to macroeconomic analysis. Margins explain the relationship between expenses that impact corporate profits. Furthermore, they are the link between the profit cycle and several other cycles, including inflation, employment, leverage, and credit cycles.
Typically, margins follow a predictable path, peaking in the middle of a cycle right around the point that the Federal Reserve starts to notice an increase in wage inflation and they raise interest rates. As they restricts their policy the corasponding rise in inflation is increasing labor costs which reduces margins. As this happens, corporations take the necessary actions to keep earnings growing by cutting costs. The most significant expense is labor, while the easiest to control is inventory.
Profit margins have been declining since 2015, not surprisingly right around the same time that the monetary policy started their restrictive policy with rate hikes and later quantitative tightening. Reliance on foreign revenue became evident with the anchor bottoming. Now we are in a situation where margins are becoming dangerously low with the massive amount of debt on hand.
The lower the profit margins, the more unwilling banks are to loan money for new projects and expansion. If the access to capital is restricted to qualified applicants only, the corporate interest rate in lower-quality debt will spike, causing already constrained firms to default on loans which will cause panic to set in. At this point, companies take precautions to maintain their earnings and start to cut costs dramatically, beginning a chain of events that leads to market crashes. I call this the Lehman Brother factor for obvious reasons.
In part three, we take a deep dive into this scenario and show you how we measure and monitor the factors that influence profit margins, with hopes that readers will have the tools needed to spot and avoid the significant life-changing moves in the market.