In order to examine the behavior of productivity and profits during a typical business cycle (Fig. 3-5), let’s start as usual with the fact that inventories are low and business decides to increase production to replenish inventories. In order to increase production, business needs to borrow money to buy raw materials, to pay wages as employment increases and to invest in new processes.
As production increases, the demand for money also rises, raw material prices move up, and as employment grows, the unemployment rate declines and eventually wages start to increase faster.
Furthermore, as production increases, capacity utilization also increases. At first, business puts the most efficient machines and processes into the production line or into the manufacturing of the product. As capacity utilization continues to rise, the less productive machines and processes are utilized. Also, as the unemployment rate declines, the skill level of the residual labor force decreases. For this reason, as the economy strengthens, productivity slows down.
As growth in productivity declines, business is not capable of absorbing the increase in wages, so unit labor costs that were initially stable because of strong productivity growth, start rising. The increase in unit labor costs, in raw material prices, and interest rates have a negative impact on profits that start to decline. Labor costs, raw material prices, and interest rates are in fact the main costs of running a business. The outcome is that as the strong economy places upward pressure on wages, raw materials, and interest rates, corporate profitability is at risk. These increased costs erode the profit margins of a company. The opposite is also true. When these costs decline, the profitability of the company improves as margins increase.
Initially, lower profits are being offset with price increases. This results in higher inflation. Of course, as we have seen in the previous section, rising inflation is followed by lower real income and slower growth in sales. Business, therefore, needs to adjust inventories downward to match the slower demand for their goods.
Also, the reaction of a typical business to declining profits is to cut costs of money, raw materials and labor. The lack of productivity also needs to be solved. Business has to think in terms of what investments have to be made to increase capacity and make the production process more effective. However, this is a long-term strategy.
In the short-term, business has to cut employment to minimize the effect of rising wages, cut raw material purchases and borrowing. However, by decreasing the costs of borrowing, the decision has to be made to delay those investments needs to improve capacity at a later date. Of course, layoffs, a cut in production and raw material purchases, and less demand for money cause a slow down in the economy.
Business will continue to cut until profit margins improve. They will improve when wages slow down quite sharply and raw material prices and interest rates also decline.
This is the time when margins improve. Business, therefore, in spite of a weak economy, recognizes that there are still opportunities in the marketplace and they will soon start rebuilding inventories and making new investments encouraged by the improving profitability, and the cycle of productivity and profit starts all over again.
As the economy becomes very strong, costs (wages, interest rates and raw materials) rise and eventually productivity slows down, due to the fact that business works closer and closer to full capacity. Initially, business tries to pass the increased costs, due to lower productivity, to the consumers. This causes inflation to rise but increasing inflation lowers consumers’ real income. This causes the consumer to spend less and the economy to slow down. This happens at the same time as business tries to cut costs to improve profitability, due to a slow down in profitability and higher unit costs. The new business cycle starts when costs decline due to the slow economy. At this time, profitability improves, due to lower capacity utilization, higher productivity and lower inflation.
1994 offers a great example of the cyclical nature of profitability. Since an investor is worried not only about profits but profits per share, which is the main driver in the price of a stock, we will discuss the example of what happened in 1992 to 1994 to earnings per share of the S&P 500. The main point of the following discussion is that changes in earnings per share of the S&P 500 follow very closely the change in raw material prices. Let’s see why.
The aggressive easing of the Fed caused the economy to expand very rapidly in 1994. The outcome of this growth was strong production, strong employment, strong income, and therefore, strong sales. As sales were increasing more rapidly than costs, profitability improved. As a result, earnings per share greatly improved with other cyclical indicators, such as interest rates and raw material prices. But eventually, the increase in interest rates and raw material prices had a negative impact on earnings per share. Business tried to control costs, and created a slowdown in 1995; as the economy slowed down, commodity prices and interest rates declined. Earnings per also slowed down with overall business conditions.
It is very important to realize this cyclical nature of earnings per share and its close relationship with trends and interest rates and commodities. This relationship is important in assessing the risk of the stock market. We will see that earnings per share is not a good timing indicator to time the overall market, but it is a more appropriate measure for selecting stocks.
(From Chapter 3 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is avalable at Amazon.com).
George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager
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