Wednesday, April 7, 2010

The Lehmann Letter (SM)


As the Dow approaches 11,000, many people ask, "What's behind this remarkable surge?" The economic recovery is important and so are low interest rates. When interest-earning assets yield little, investors are more likely to turn to the stock market.

But corporate earnings have been crucial, too. Recently the Bureau of Economic Analysis announced fourth-quarter 2009 after-tax corporate profits: (See line 45 at this link.)

After-tax corporate profits increase by 50% over the past year to $1,270.1 billion in the fourth-quarter of 2009. If you plug that number into the chart below you will see how swiftly earnings have recovered.

After-tax Corporate Profits

(Click on chart to enlarge.)

Recessions shaded

But the recovery in profit margins has been even more dramatic. (Profit margins are profits per unit of output. Total profits equal the profit margin multiplied by the number of units sold.)

It is difficult to obtain a precise profit-margin figure across all sectors of the economy. So economists use the ratio of the implicit price deflator divided by unit labor costs as a proxy. Think of this as price divided by cost. If the number rises, that's a sign that profit margins are rising. If the number falls, profit margins are falling.

You can find the latest figures for the implicit price deflator and unit labor costs at the Bureau of Labor Statistics website:

The most recent figures (price/cost) are rising: 106 in the second quarter of 2009, 108 in the third quarter and 110 in the last quarter. Also notice that prices have been fairly steady but costs have recently declined. That's why the ratio has risen.

When you plug the latest number (110) into the chart below, you can observe profit margins' unusual record during the recent recession. This is the first recession since 1949 in which profit margins gained, and you can also see the extraordinary heights to which profit margins have climbed.

Corporate Profit Margins

(Click on chart to enlarge.)

Recessions shaded

This outcome derives from unusual developments during the recent recession. Slack demand has held prices and wages in check. But productivity (output per hour of work) has continued to grow. Consequently unit labor costs (the cost of producing a unit of output) have fallen because less labor time is required to produce each unit of output. Since labor input is down and wages have not risen, the cost of producing each unit of output has declined.

Mass unemployment has been the key consequence of rising productivity. Employers are using far less labor to produce a smaller quantity of output. As a result output per hour overwork has risen. This has held costs in check and thereby boosted profit margins.

Total earnings should grow as sales volume recovers in the face of these robust profit margins. Investors have seen this and rushed into stocks.

(The charts were taken from [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of economic indicators.)

© 2010 Michael B. Lehmann

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