Wall Street strategists who some people unkindly classify as "cheerleaders" have recently been explaining why their stock market predictions have been so sorrowfully wrong this year. Sorrowful for investors, that is, because the Street gang themselves took home hefty pay packages, in compensation for their valiant marketing efforts. Only a tiny minority went against the consensus view, which was - guess what? - predicting a very ebullient outcome. Be it noted that the rose-coloured glasses haven't entirely come off yet.
The folks who got it so wrong explained that the principal reason for missing the target was the occurrence of "intangible" issues such as accounting shenanigans, corporate misdemeanour and the war on terrorism. Now, clearly, we cannot disagree with them that these factors have indeed played a role, mainly on the psychological side. However, even more importantly, there are "tangible" (i.e. more substantial) reasons why the equity market is, and will remain, challenged. It has to do with the limits on the rebound of corporate profitability.
The exaggerated and deceitful presentation of earnings that is currently being exposed is not a recent phenomenon. It appears to have been diligently practised over a long span of years. During the past decade, fraudulent performance results gave rise to all sorts of fanciful talk about the promise of new technology and the speed of productivity growth. Those of us with a sceptical turn of mind raised doubts, well before it became fashionable to do so - - that the implementation of new tech and the rapidity of productivity growth do not necessarily result in fat profits.
It was normal to be suspicious of the rosy earnings-growth numbers that were being consistently reported by corporations, when the aggregate profit performance in the GDP national accounts figures looked so mediocre. What's more, the extravagant earnings claims were made right in the face of the intense pressures of a highly competitive pricing environment. The illusionists created a picture that looked extraordinarily good but is now shown to be inauthentic.
Some realism about profit growth
On average, profits grow broadly in line with nominal GDP. They can however advance at a more robust pace, over certain periods, if distributive shares swing in favour of aggregate profits, and this has to come, principally, out of the hides of households, in the form of a lower labour-income share. This is where much of the real stuff is for boosting corporate profitability. How to get at it, means putting the squeeze on employees - - resulting in healthier corporate bottom-lines.
Disoriented folk are trying to piece together what’s left of the "American economic miracle" and are grudgingly admitting that its "real" productivity-growth performance is going to be closer to that of its principal competitors than was believed hitherto. And, naturally, some investors are asking themselves if they are paying too high a premium for U.S. assets - - remembering that lots of foreigners fell for the productivity-miracle story in the previous decade and queued up to buy American securities, as well as hard assets.
Enthusiasm for portfolio investments, as well as direct investments, has waned a great deal now - as evidenced by the data - and this has implications for the sustainability of the massive current account deficits regularly run up by the United States. Up to now, the optimists had always brushed off concern about the deficits with the argument that it wasn't a problem because capital was considered to be earning a superior return in the high-productivity U.S. economy, relative to other locations.
If other major economies aren’t going to grow much faster than the U.S., which seems probable, then there is likely to be a process of adjustment in which American households end up by consuming less and saving more, and the dollar heads lower. When foreigners refrain from financing U.S. deficit spending then domestic sectors have to take the strain and adjust in the direction of achieving a balance or a surplus.
The time may be approaching for households to finally pull in their horns. At the same time, it is not going to be an environment in which firms will jack up their capital spending a great deal. Indeed, they should be busying themselves with repairing their balance sheets, often loaded with too much debt and overvalued assets.
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