Thursday, February 2, 2012

Productivity and Profits: The Impact on the Stock Market

The Lehmann Letter (SM)

Many investors have a clear idea of the relationship among productivity, profits and the stock market. They ought to move together.

So today's Bureau of Labor Statistics report that productivity grew in 2011's last quarter is good news:

But there was even better news buried in that release: Prices continue to improve more rapidly than labor costs, thereby generating generous profit margins.

Ratio: Implicit Price Deflator to Unit Labor Costs

(Click on chart to enlarge)

(Recessions shaded)

The top chart provides a good proxy for profit margins. Just a quick glance shows how they have improved over the past decade. Profit margins are now at an all-time high.

After-tax Corporate Profits

(Click on chart to enlarge)

(Recessions shaded)

The next chart demonstrates that profits have recovered from the recent recession and are also at an all-time high. But they don't show the exuberance of profit margins. Why?

Because total profits are the product of profit margins multiplied by sales volume (profit margins X sales volume). Profit margins may have risen to an all-time high, but sales volume remains in the doldrums for many firms.

It appears that profit margins have risen to their limit. We can't expect productivity to continue growing sufficiently rapidly to further boost productivity above its current record-high level. Sales volume must now grow strongly for earnings to continue their upward march.

But where will those sales come from? The economy's prospects going forward are too weak to provide robust sales-volume growth. That means most of the biggest profit-gains are behind us.

This is not good news for the stock market. It may be true that productivity continues to improve, and it may be true that profit margins remain robust. But the outlook for sales-growth is not that rosy. And without that growth, earnings cannot improve rapidly. Investors should remain wary of this.

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© 2012 Michael B. Lehmann

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