One of the great things about travel is the opportunity to see how other countries and cultures work. On my annual sailing trip in the Caribbean last month I left the nation of St. Vincent and the Grenadines by boat, and entered the neighbouring country of Grenada. In each case this involved visiting the offices of customs and immigration. Now both of these are small countries, each with populations under 150,000, and they are far from wealthy. Tourism and subsistence agriculture are the main industries. None the less, there are internet cafes and hot spots in the larger towns, and most everyone has a cellphone. Somehow, this technology has not penetrated the musty corners of government where tired and sweaty yachtsmen gather to have their papers checked and stamped.
In both countries languid officials fill out forms by hand, in triplicate, interlayered with carbon paper. I didn’t actually know that carbon paper still existed as an office product. A process which must be repeated twice every time a boat crosses the international border is performed in the same manner in which it was likely done 100 years ago, and at the same speed. One must assume that the governments of the two nations involved have decided that employing a few extra civil servants (a valued job) is more important than productivity.
Productivity may not be important to governments (some would argue that, to the contrary, governments exist to increase unproductivity) but it is certainly important to companies. Productivity means getting more output with less input, and not infrequently, that means less input of labour. Technology is frequently the catalyst for increased productivity. The office computer is probably the example that springs most readily to mind. The increased use of automated industrial processes, which we can think of as robots, is the next step in the productivity chain, and it is causing profound changes to industry. It currently takes, on average, about 26 hours of labour to produce a car in North America. Thirty years ago it took 50% more, 39 hours per car. This means that today, the same number of vehicles can be produced with only 2/3rds of the workers. No wonder the number of auto workers continues to shrink even though the car industry is on track for a very strong year.
Further examples are everywhere. Construction workers who once swung hammers now wield nail guns. Parking lots formerly managed by the guy in the booth now use labour-free park and display systems. Bank tellers are displaced by ATMs and on-line banking. Supermarkets are rushing to adopt do it yourself check-out. In all aspects of the economy the relentless drive for productivity has displaced labour, made long held jobs obsolete, and has enriched corporations.
Corporate profit as a share of the US economy was very stable for a very long time. Between 1953 and 2003, a fifty year span that included four major wars, ten Presidents (six Republican, four Democrat) and major shifts in demography and sociology, corporate profits were always between 3% and 7% of U.S. gross domestic product. Something changed about ten years ago, perhaps not coincidentally, just at the time that the internet, email and cellular technology exploded into everyday use. The share of corporate profits started to rise, and with the brief hiatus caused by the recession of 2008/09, have continued to rise.
Corporate profits have risen past 10% of GDP for the first time, and are poised to enter new territory above 11%.
Not surprisingly, the story for labour is exactly the opposite. Stagnant wages, lower labour force participation (mostly involunantary) and forced early retirement have driven the share of the economy represented by wages down to new lows. Where wages made up over 50% of the economy as recently as 1975, and accounted for 49% in 2000, today they are only 44%.
This is a profound change in the nature of the world’s largest economy, and rather than being a temporary aberration, it appears to be gaining momentum. It is an important cause of the inequality of wealth and income which inspired the “Occupy” movement in 2011. The very low interest rates over the past five years have, if anything, strengthened this trend, as cheap money makes it easier for corporations to substitute capital for labour, by making more investments in new technology.
For investors, the key question has to do with the sustainability and direction of corporate profits. When we buy shares in a company, we are buying a piece of the future income that it will earn. If, as some analysts think, corporate profits are at unsustainably high levels, then we should pay somewhat less for those future profits, which will likely be lower than they are now. If, however, we believe that there really has been a fundamental shift in the nature of the developed economies which has resulted in corporate profits moving to a new and higher level on a permanent basis, then we should be happy to pay up for this growing flow of corporate cash.
The S&P 500 Index of the largest public companies in the US currently trades at about 15 times the expected earnings for those companies in 2013. This is slightly below its long term average of about 16.5 times. If corporate profits are doomed to fall back to long term norms below 10% of GDP, then the S&P 500 is fully valued, and we should be cautious. If the paradigm truly has shifted and corporate profits continue to accelerate, then stocks are cheap and should be purchased aggressively.
There are lots of moving parts in any economy, and particularly in the largest one in the world. The direction of Government policy, the intervention of central bankers in the financial markets, the effects of changes in interest and exchange rates – all of these have major impacts on short run performance. Against this background of short term effects, however, long term trends play out. We believe that the growth in corporate profits as a share of the total economy has changed permanently, and that corporate profits will continue to grow; conversely, we think it is likely that wages paid to labour will never again reach the 48% level that was the norm a generation ago. For this reason, among others, we think that the stock markets still offer attractive opportunities for investors, even as they reach levels last seen in 2007 and 2008.
