Let me say it has been a couple months since I’ve felt compelled to post which may account for the length of this latest piece but I hope and believe most will find it worth the full read. A coffee and 10 minutes (ok maybe 15…) are a perfect compliment to this piece.
Well it’s official markets have moved into a frenzy of absolute insanity with 6% swings in expected future cash flows every couple days. It means the models have broken down. But price insensitive ‘investors’ managed to prevent a reconciliation between economic and market performance last year despite revenues and earnings now also having broken down. It’s impressive and depicts the ability of the Fed to impact MARKETS if not the economy.
But it also highlights the incredible lengths CEO’s have (perhaps understandably) gone to defend market cap. Now that the Fed has boxed themselves out of the equation, neither able to raise again or cut rates without either action punishing the market, it is back to the underlying fundamentals. And that means it is time to understand how the Fed’s policies and the market’s delusional expectation of perpetual earnings growth have led CEO’s to misallocate hundreds of billions in capital, actually destroying the mechanism for economic growth itself, namely, demand.
I’ve talked ad nauseam about how the natural bond between profit and labour has broken down (now don’t roll your eyes I’m about to take you to places you’ve never been before). And this is a direct result of incredibly destructive economic policies, both fiscal and monetary. I’ve discussed the idea that there is a mathematical critical point of narrowing income distribution below which an economy simply cannot grow no matter how much money is injected.
I’ve also discussed the idea that profits can only grow in the face of declining demand by cutting costs and contracting operations. That is, cut labour and capex to reallocate those funds into income, share buybacks and dividends. This is exactly what CEO’s have been doing for the past 6 years while they wait for consumer demand to improve. However, I have also suggested there is a limit to the financially engineered earnings growth. When the cash dries up so too does the engineering. The hope in such a strategy is that demand returns before the cash runs out.
In early August I offered a chart and predicted an imminent major market selloff. The basis was that earnings had finally rolled over despite the financial engineering. The reason is that cashflow can only be supported by costless borrowing and operational contraction until the lending slows and all the fat is trimmed, at which point the well runs dry and the financial engineering becomes impossible.
The problem is that financially engineering earnings to defend market cap is a very short term solution to a longer term fundamental problem. Demand, or more rightly, lack of demand is what leads CEO’s into such extreme market cap defending strategies given the market’s belief that profits must always grow for a firm’s valuation to even remain stable.
However, financially engineering earnings growth actually further deteriorates the very demand that is to alleviate the need to financially engineer earnings growth. You can see the conundrum. Sort of like a man stuck deep in the forest with two broken legs. He begins to starve and decides well his legs are broken anyway so he’ll just eat his legs to obtain the calories necessary for survival not recognizing those are the legs needed to carry him out of the forest.
We all understand that demand is the key to sustainable earnings growth, that’s easy. But the next step in the syllogism is where things go terribly wrong. The Fed believes demand is a function of interest rates and a very distorted definition of full employment. However, if you’ve been following my articles for the past 2 years you’ll know my theory is that demand is a function of income distribution or labour.
Now when I discuss income distribution a lot of people say to me “blah blah blah…. income inequality… blah blah”. The suggestion is that I’m a bleeding heart. My response is that income ‘disparity’ is not a moral issue but a mathematical one. People then like to remind me that total income is at a record high. But what they fail to understand is total income has very little to do with demand (this is due to diminishing marginal propensity to consume). Income distribution or labour income is demand’s real master. This is why economic policy must target sustainable demand, which is a function of sustainable income distribution or labour income for which we will use ‘salaries and wages’ as a proxy.
Now I must digress for a moment, when doing this type of research it is imperative to understand the data. It is very easy to simply discuss personal income. However, when one looks into what the BEA includes in personal income you see that, today, 50% of personal income is made up of dividends, interest and rent. These are things that are generally not being earned by 90% of workers.
Further, these are income sources that are generally reinvested back into secondary financial markets. Capital invested into secondary financial markets generate essentially zero economic output. And so it is necessary to separate such income from income that does generate economic output via consumer demand.
This is why I’m using salaries and wages as a proxy for income distribution or labour income. That is, generally salaries and wages are being used to consume and consumption is realized demand. Sustainable demand is the holy grail and so demand inducing income, or labour, is where it all begins.
Remember profit is the subsistence of labour and labour (consumer) is the subsistence of profit. Neither maximizing profits at the expense of labour nor maximizing labour at the expense of profits are optimal macroeconomic behaviours. Optimal behaviour is finding the sweet spot of capital allocation between profit and labour such that each actually works to compliment rather than cannibalize the other. When the equation gets out of whack in either direction the entire system takes it on the chin.
Before jumping into it we have to remind ourselves how profit is derived. Profit is the difference between revenue and all the costs associated with obtaining that revenue. Theoretically assuming costs are zero then maximum profit equals total revenue. So we know that profit must be something less than revenue. But so how is revenue derived?
Well revenue is derived from consumption and consumption is derived from labour incomes and supplements to income i.e. consumer debt and social welfare. And so if we theoretically assume no savings then maximum revenue is equal to total income + total consumer debt + total social welfare. Which then means theoretical maximum profit is equal to total labour income + total consumer debt + total social welfare.
And so this provides an incredibly useful equation. What we’ll see is that nominal profit growth cannot exceed nominal growth in salaries and wages + supplements. And we can observe this law.
What we are suggesting is that change in profit cannot theoretically exceed change in income plus consumer credit on the macro level. Remember if we assume no cost then maximum profit = total revenue, which is derived from income and credit. So any change in profit (i.e. nominal growth) cannot exceed the nominal growth in revenue, theoretically.
Notice the chart depicts only two anomaly periods and that they congruently and immediately follow the 2008 recession. The BEA follows NIPA which allows corporations to expense losses before they actually happen. It essentially under reports profits in the period of reporting and thus over reports profits in the immediately following periods (an accounting standard used heavily during recession – note the grey shaded bars are periods of recession) which explains the anomalies we see in the above chart. Excluding those immediate post recession reporting periods we find our theory holds. Namely, nominal growth in profits does not exceed nominal growth in labour income plus supplements.
And so we’ve shown both theoretically and by observable data that nominal change in profits cannot exceed nominal change in labour incomes and supplements. This provides a very observable constraint on profit. This becomes very relevant when we look to predict profit growth as a basis for equity valuations on a macro or market level as we will soon see. It also provides a starting point to understand the driving dynamics of an economy and thus an ideal target for economic policy. But let’s first have a look at profits in terms of equity valuations.
CEO’s have a few tricks they can use to engineer profitability on a micro level and we’ve all heard about them. Share buybacks and dividends. For several years CEO’s have been led to defend market cap by creating a facade of earnings per share growth by way of reducing the amount of outstanding shares and by boosting dividends. What we will see a bit later on is that this behaviour actually perpetuates the underlying demand destruction that pushed CEO’s into these strategies in the first place. And so what seems like a short term solution is necessarily leading us off the economic cliff.
The reason is that in order to fund these strategies cash must be reallocated away from human and fixed capital, in effect contracting operations and distorting the natural balance between profit and labour. Let’s have a look at the strategy playing out over the past 15 years.
Note that the peaks in buybacks and dividends correspond to peaks in market price levels (positive correlation). This is counterintuitive in that typically firms buy back shares when they believe price levels are grossly undervaluing their equity (typically a negative correlation between growth in buybacks and market cap). And so one can logically infer a causation effect between buybacks and market cap when their correlation is positive.
That is, the act of the buy backs are intended to push market caps higher or the buy backs would end well before the market peaked at all time highs. However we observed that the buy backs continued to increase right into the market peaks in both ’07 and ’15 even as profits rolled over. In other words CEO’s are not choosing to buy back stocks for the traditionally understood reason of undervalued market caps but to defend and actually push market caps.
Some will argue that CEO’s implement such financial engineering to fluff their own compensation and others will argue it is simply the only thing they can do to defend shareholders’ value for which they have a fiduciary responsibility. The reality is it doesn’t so much matter what their intent is but of the results. Do such strategies work? The answer is on a micro level they can be very effective. But if economic policies have created an environment (low demand) in which all CEO’s are taking on such strategies it becomes a malignant force that infects the overall economy and thus all firms individually as well beyond the very short term.
So let’s start getting into the meat and potatoes of what I’m proposing. As we’ve discussed there is a natural limit to profit growth. Specifically profit cannot grow faster than labour income plus social welfare plus consumer credit. Looked at another way the ratio of Nominal Profit Growth/(Nominal Growth in Income and Consumer Credit) cannot exceed 1. Generally the ratio will be somewhere between 0 and 1 (however it can theoretically be negative for short periods).
As the ratio moves from 0 to 1 it means that a larger proportion of revenue (a function of income and supplements) is being (re)allocated directly to profit in lieu of labour and capex. Revenue allocated to profit directly is an extremely inefficient use of capital in an economic context (meaning it does nothing to directly boost economic output). That said, it doesn’t follow that a lower ratio is necessarily better. Remember the objective needs to be optimizing capital allocation in such a way as to compliment both profit and labour. So we want to find the sweet spot of capital allocation between profit and labour such that each is complimenting rather than cannibalizing the other.
If we find a sweet spot from the data then it would follow that capital allocation mix is a much more prudent and rational target of economic policy than the Fed’s existing mandates. Interest rates can be a tool of economic policy but it is not an economic objective or policy in and of itself. Lower interest rates can, in certain instances, indirectly lead to greater demand but with very low probability and a heavily diluted affect. And so the fact that interest rate setting is the Fed’s primary mandate is absurd. So why do they use it? Well because interest rates are manipulated through money creation, which is precisely what the Fed wants to control.
The Fed uses its other mandate of full employment as a gauge to judge the effectiveness of its interest rate policy. However, if your definition of full employment is absurd, as is the U3 or even U6 statistic (excluding any unemployed that has not looked for work in the past 4 and 52 weeks, respectively), then your measure of effectiveness is going to be wrong.
This is exactly what we’ve been forced to swallow for the past six years. The Fed has used interest rates for six years now to create full employment, which they believe to be a U3 print of 5% (which excludes all unemployed persons that haven’t searched for work in more than 4 weeks). They believe a U3 defined full employment equates to strong demand, which we all agree is the ultimate target. But ZIRP has done nothing to create full employment as evidenced by the continued abysmal demand. And so it is necessary to accept that the Fed’s defined mandates do not work to generate demand. It is a simple fact and a very logical and common sensical one at that.
Therefore, any agency, be it the Fed or Congress, defining its economic policy mandates as interest rate and U3 full employment are wholly misguided. As such it is no wonder the Fed has done such a miserable job at actioning a stable economy over the past 100 years. Their targets are obscure, indirect and simply wrong and are truthfully intended for another objective altogether i.e. money creation. What I’m about to do is show that economic policy should be focused on the capital allocation between profit and labour in accordance to their natural optimum relationship. Let’s do that.
The following scatter plot depicts that personal consumption i.e. realized demand can also be defined as salaries and wages plus social welfare plus consumer credit less personal payments to government less interest payments.
The above chart evidences that realized demand or personal consumption (which makes up around 70% of GDP) is not only theoretically driven by labour income and supplements but that the level of realized demand is essentially perfectly correlated to such. Now I know the statisticians out there are going to suggest that I didn’t regress change in levels but the level itself. This is one of those instances that we are interested in levels not the minute change in levels. Changes period to period are influenced by a black box of inputs, however, while those may be interesting we are seeking to substantiate the theory that realized demand (total level of personal consumption) is driven by labour income and supplements as noted above. This chart certainly validates the theory.
Now I use consumption, demand and labour essentially interchangeably. This is the most important concept of this research. This hits on the very key that labour is demand and demand is profit. It intrinsically ties these concepts together. In a sense it is the holy trinity of economics; The Labour, The Demand and The Economic Profits. However, unlike the Holy Trinity that was decreed by way of council vote, the economic trinity is absolute in that it is so by way syllogistic universal law. No amount of Fed discussion or corporate cronyism can ever change the inherent sustainable relationships between labour, demand and profit. To further show this let me show you the profits’ relationship to demand and labour.
So the above chart compares two ratios, profit to labour and profit to personal consumption expenditure i.e. realized demand. While the scales of the two ratios are slightly different the relationships are essentially identical. What the two preceding charts so clearly evidence is that there is a real definable syllogism between profit, demand and labour. If Labour then Demand; If Demand then Profit; Therefore if Labour then Profit.
The economic cycle necessarily requires profit and labour and these are inherently tied together through demand. However, what we find is that the economic trinity is only absolute in one direction. That is, if Profit then Labour is not an absolute law but a choice of allocation. Because the profiteers are also the capital allocators, the capital allocation mix becomes increasingly skewed toward profit when macroeconomic policies incentivize short term profit taking over longer term sustainable profits. Exactly the trap we have cyclically found ourselves in over the past 20 years, which exacerbates in magnitude with each passing cycle.
Now we must accept that labour income and supplements are the drivers of demand and so we need to explore the driver and sustainability of these factors. It is important to understand that we are targeting sustainable demand. And so understanding the relationship between each parametre in the bucket of drivers is essential.
Specifically, how are each changing relative to one another and are those trends sustainable? Logically we know that consumer credit or the payment of is a function of income. That is, we require income to pay down credit balances. And so there is some limit of credit relative to income beyond which the extension of more credit is not viable. Let’s have a look at the trend.
The above chart depicts fairly material growth of total consumer credit relative to total labour income, having almost doubled since the early ’80s as a percentage of income. This begs the question, how large a percentage of total income can total consumer credit be before it is no longer sustainable? This I will leave for the experts to debate. But also how will demand be impacted when that limit is reached? This one we can actually decipher.
The above chart tells us that over the past 20 years annual growth in consumer credit accounts for 1/3 of the growth in demand up from 1/6 during the prior two decades. And so if consumer credit were to plateau or decline we can calculate the respective impact to demand. I’ll leave it to you to do your own sensitivity analysis and note we can do the same thing for welfare. However, more importantly then is sustainability of labour income as credit and welfare are both a function of labour income (via lending and taxes). And so this brings us to the main event. Specifically, how can we promote sustained labour income? If we can find that then we have discovered a much better macroeconomic policy mandate.
The following chart seems simple on the surface. What I’ve done is to chart the relationship between profits and labour in an effort to determine if we can derive changing trends over time and if so then from that we can determine an (economically speaking) optimum range of capital allocation between profit and labour, such that the two compliment rather than cannibalize the other. And that is the true ideal state of capitalism.
What we find is that profits’ share of capital has been growing significantly over the past two decades. Let’s add credit and welfare to income.
The above chart depicts total corporate profits with inventory and capital adjustments over salaries and wages plus total social welfare plus total consumer credit. In effect, it tells us what percent of realized demand is being allocated back to profit (in lieu of being reinvested into operations). We find that over the past decade we’ve seen an unprecedented capital shift toward profit and thus away from labour moving from a 30 year average of .14 to .22 today, 60% above the long term average.
Now while the above chart depicts an interesting trend it doesn’t give us much useful information. So what happens when we add some economic indicators to the chart? Well let’s add M2 Velocity, which is simply an efficiency gauge. Specifically it tells us how much output (GDP) we are generating from each printed M2 dollar. Another way to see it is how much money stock do we need to maintain growth in GDP. What we see is fairly disconcerting generally and also seems to support our theory.
In the three decades leading up to the new millennium we note a fairly positive correlation between our ratio of profit to labour and M2 Velocity. However, a major downward trend in efficiency begins in 2002, the very moment the massive uptrend begins in our ratio of profit to labour. Because of the sharpness of the uptrend we know that strategies were being implemented in 2002 to drive this shift to profit and away from labour. Now our theory purports that profit is a very inefficient use of capital in economic terms, so the fact that M2 velocity collapses at that point supports our theory.
Another interesting ‘sweet spot’ comparison is real S&P price level growth vs our capital allocation ratio. The above chart is shaded blue from 1982 through 2000 which corresponds to the period shaded blue in the next chart. It was during this period that the S&P, in real terms – so adjusting out gains due only to inflation- had its greatest and only sustained growth since 1913. This blue period in the above chart depicted a capital allocation mix with profits averaging around .14, much lower than today’s ratio of .22.
Quite shockingly, you’ll note that by 1982 the S&P, in real terms, was back to the level it was in 1913. So all nominal growth from 1913 through 1982 was simply inflation. Between 1982 and 2000 we saw tremendous real growth that has not been given back. However since 2000 the S&P is flat in real terms and any growth is again nothing more than inflation.
So it would seem the only period since 1913 that has provided sustained real growth on the S&P is the period that saw a capital allocation mix giving profits around 14% of consumption. This was also the best period of economic efficiency over the past 100 years. So both markets and the economy performed best when the capital allocation to profits was around 14%.
So let me wrap this all up in a neat little nutshell. The point of this paper is to prove that there is a natural and absolute relationship between profit and labour. Further we can observe changing capital allocations between profit and labour over time and thus we can identify the capital allocation ratios that produce the optimum economic outcomes, which drive real market performance.
Because of the absolute laws of the economic trinity, capital allocation becomes an ideal policy mandate, a true policy mandate that directly affects economic outcome. While interest rates can be a tool to incentivize appropriate capital allocation it is not a policy in and of itself. While employment can be a post policy gauge as to the effectiveness of the policy it too is not a policy in and of itself. Because, as we’ve shown, capital allocation between profit and labour actually drives economic performance both in theory and in practice, this should be the main economic policy target. Remember capitalism is the allocation of capital to investment for profit.
If you are still on the fence let’s take in one final visual to solidify the point that without labour, profit is doomed (and thus labour is circularly doomed and the spiral develops). Acknowledge the period between 2007 and today the Fed has printed more money than in the 250 years up to 2007 combined. Yet even with the most extreme monetary policy i.e. interest rates at 0% and U3 unemployment of 5% capital orders and manufacturing have just moved back to contraction, a clear sign of recession.
But how could this be given the most historically extreme monetary policy in place for 7 years? Well look at real labour in the chart below. Breadwinner jobs have been reallocated to profit and that, as we’ve discussed, is a deathblow to both the economy as a whole and thus to the market as profits too have necessarily rolled over and no hope for demand improvement.
In short, because our macroeconomic policies have false targets and actually incentivize short term strategies the Fed has directly led us off of an economic cliff. Now that the Fed has boxed itself out of any further action, the market is at the peril of a collapsing, breadwinner jobless and debt ridden economy and so prepare yourself for the largest market ‘correction’ the world has ever faced. It surely isn’t the end of humanity but it will have a tremendous negative impact on what remains of the economy. Let’s hope it triggers a better discussion and thus a better way forward this time around. The world can actually be a better place but we have to be adamant that that is the true intent of each policy. And on that we the people need to do a far better job of making our voices heard.