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Curb Your Enthusiasm

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Last week was an interesting week for economic news. For example, 1Q-2016 GDP growth was revised up to +0.8% but that was less than the +0.9% expected. Business spending on capital goods and corporate profits continues to grow at a negative rates. And perhaps most importantly, Janet Yellen said the federal funds (interest) rate will “probably” rise in the “coming months”.

Profits-GDP_2016-05What I found most interesting about last week’s economic news actually wasn’t widely reported: corporate profit’s share of GDP (“Profits/GDP). If you click on the accompanying graph, then you will see Profits/GDP going back 69 years. Over that time period, it has normally ranged between ~5% and ~7% and has averaged 6.0% (yellow line).

 

According to Warren Buffett . . .

I bring up Profit/GDP because I was reminded by a colleague that Warren Buffett discussed Profit/GDP at the height of the Tech Bubble in an article he co-authored for the November 1999 edition of Fortune magazine. It was in that article, months before Tech Bubble imploded, the Oracle of Omaha warned investors to curb their enthusiasm and expectations for high returns. He argued one of the two ways for investors to achieve juicy profits in the market over the long-term would require Profits/GDP to rise. In other words, profits would need to rise faster than GDP. (The other way would require interest rates to fall even further!)

As you can see in the graph, Profits/GDP, in late-1999 when the Buffett article was published, were already in decline. Despite the strong economic growth and very high productivity at the time of the article, a stock market crash occurred less than a year later and that was followed by a recession (grey shaded areas) less than two years later.

 

Decline By How Much?

Profits/GDP have been reverting back to a more normal range. In fact, Profits/GDP have most recently decreased from its peak of 10.1% in late-2011 to 7.6% in early-2016. Hence, Profits/GDP has decreased by 2.5% or 250 basis points (“bps”) over the past 4+ years. This is worth noting because declines of 200 bps or more (red lines) have in the past 69 years always been followed by recessions.

To be clear, not all recessions were preceded by declines in Profits/GDP of 200 bps or more: some recessions were preceded by small declines. Nevertheless, declines of 200 bps or more have always led to recessions. So does that mean a recession is now imminent? Not necessarily, but if this is indeed signaling a recession, then investors should curb their enthusiasm and expectations for high returns.

Whether or not you believe declines in Profits/GDP constrain stock market returns or is a leading indicator of economic recessions, please consult an investment fiduciary before making any investment decisions.

 

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