September 2006
While having a national holiday like Labor Day in their honor is nice, we would bet the average working men and women of this country would trade that in for a bigger piece of the prosperity pie that the U.S. economy has been baking over the past four years. Corporate profits have been soaring while wages and benefits have not even kept up with the rate of inflation over the last few years. This is becoming as much of a political issue as an economic one going into mid-term elections. With the paychecks of working families failing to keep up with inflation and the housing market declining, we are concerned about the underlying strength of this economy despite record profit growth.
One of the distinguishing features of this current economic expansion has been the tremendous rise in corporate profitability. The S&P 500 companies as a group have generated 17 consecutive quarters of double-digit earnings growth and analysts expect to see number 18 at the end of September. For those of you who need help with the math, that is 4 1/2 years of rapid growth!
A major contributor to that profit growth has been expanding profit margins. Most companies are adding more to their bottom lines with each sales dollar than they have since the 1960's. Corporate profits have reached their highest share our nation's gross domestic product (GDP) in 40 years. As the investment bank, UBS, recently stated, it has been a "golden era of profitability".
One would think that with Corporate America benefiting to such an extent from these 4 years of strong economic expansion, life would be good on both main street and Wall Street. Both workers and investors should be happy. Unfortunately that does not seem to be the case. Neither group feels they have much to smile about and that is a "conundrum" worrying Republican strategists as we head into elections this fall trying to protect their turf.
The fact is during this golden era of profitability, wages and salaries (including benefits) have failed to rise on a real basis (after inflation) and now represent the lowest share of GDP since 1947 when the government started keeping track. Labor's shrinking share of the economic income pie has been the most important contributor to record high profit margins.
As stock market investors we applaud corporate management's efforts to control costs and raise profitability. That produces higher stock prices. However, we worry about the long-term consequences of an economic policy or strategy that contributes to the widening income distribution gap between the top 20% of income earners and the bottom 60%.
Last year the top fifth of American households received just over 50% of all income, up from about 43% in 1975, according to the Census Bureau. The bottom 60% share of income declined from about 32% to about 27%.
Economists have always said that the only way to increase the standard of living for all working people in an economy is to increase the productivity of the workforce. That means producing more stuff and services with the same amount of labor in the same amount of time. This allows companies to pay their people more without sacrificing profits to do it or having it lead to higher inflation down the road. This economic theory was proven to work in the real world as both productivity and wages rose rapidly in the 1950's and 60's and then more slowly in the 70's and 80's.
Over the past four years the relationship between higher productivity and paychecks has broken down. Pay increases have not kept up. Labor Department figures show that labor productivity increased almost 17% from 2000 to 2005 while total compensation for the median worker only increased about 7% and most of that was from benefits. Instead of using the majority of those productivity gains to increase their workers paychecks, management used them to beef up their companies' bottom lines to earn their annual bonuses.
This stagnation of real wages for average working people has been caused by a weakening in bargaining power. Global competition, advances in technology as well as immigration have made people feel less secure in their jobs. In addition, trade unions have lost members as companies closed plants and offices in the U.S. only to open up the same operations in a country where the wages and other costs of doing business are a fraction of what they are here. It is difficult to ask for a raise with that threat hanging over your head.
Over the past three years or so many people have been making up for their lack of real income growth by using their homes as ATM machines. They would take some of the equity out of their houses every time they refinanced their mortgage and use it to buy things or payoff credit cards. With housing prices now stabilizing and even falling in some areas of the country, that game is over. That ATM machine is closed.
Recently there has been some encouraging news about wages for the average worker. With the unemployment rate at a relatively low 4.7%, real average income has been on the rise. Many companies are finding that they have to be more generous with their employee compensation to attract and keep the people they want.
Even government is getting involved to help working families on the lower end of the income stratum with proposed increases in the minimum wage. Unfortunately all of this is happening when the economy is now showing signs of slowing and the risk of a recession has to be considered, especially if housing prices fall more than expected. Productivity gains are also slowing leading to concerns of higher inflation.
We think the golden era in profitability is coming to an end. Profit margins should feel the squeeze from slowing sales and higher wages and benefits going forward. While many corporations have stockpiled a lot of cash, they have not been putting it to productive use to help grow profits in the future. We remain very cautious about the stock market and maintain our defensive strategies.
John W. Gudritz, CFA
john@frontstreet.com