Corporate Earnings: Cycle, or Trend?
Board: Berkshire Hathaway
As I understand the case for the U.S. stock market as a whole being significantly overvalued, it is based on the assumption that above-trend corporate earnings must inevitably return to the trendline. Wary as everyone is of the "This time it's different" mantra, this piece makes the self-evident case that the increase in corporate profits has come largely from increases in productivity, or, to put it another way, decreases in labor costs. If that's true, doesn't one have to be able to envision labor regaining leverage to assume that corporate earnings return to the trend line?
Disclosure: I'm a big proponent of the "broad US equities are overvalued because profits this high won't last" school.
But my view is that there is a difference between reversion to the long run mean of corporate profits and reversion to the trend line. This is true whether it's in real dollars or as a share of GDP. Even if there is a long term trend of labour getting less and less of the pie, at least a reversion to that trend line would seem to be a conservative assumption.
If you make an assumption that the trend of real corporate earnings will continue to rise higher and higher at a rate greater than real GDP growth as it has been in recent decades, current real corporate earnings are still around 25% above even that rising trend line. In round numbers we're seeing $88 earnings for the S&P 500 while even the rising-much-faster-than-GDP trend would indicate around $70. There is no need to assume that corporate earnings will fall to their long run average as a share of national income to make a case that earnings are unsustainably high right now. Heck, there's always another recession coming.
FWIW, automation is a big issue but I think the falling share of US national income going to labour has more to do with a billion or two poor people being able to enter the global labour market in away that competes with until-recently overpaid blue collar people in rich countries. US assembly line workers were probably never worth $40,000+ a year. I think we are perhaps coming to the end of a one-time historically anomalous period that people with few skills could get high incomes in rich countries. On this view the recent decline in the share of US national income going to labour is the reversion to the long run mean and the previous high level was an interesting but ultimately unsustainable exception.
A lot of interesting discussions come out of trying to distinguish between cycles and trends!