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I showed in my previous blog that the ratio of depreciation to operating profits is much higher in the published figures for Japanese non-financial companies than it is for their US counterparts and that this could not be justified in terms of either the amount of equipment that needed to be depreciated or the rate at which it should be written off. There is therefore a strong implication that Japanese profits are understated relative to US ones, but this is subject to two provisos.
First, even if the ratio of depreciation to output should be the same in both countries, the ratio of operating profits could be very different if US companies had much higher ratios of profits to output than Japanese ones.
In two earlier blogs I explained why the cyclically adjusted price earnings yield (Cape) could not sensibly be applied to valuing Japanese shares. (One of several reasons is that Cape is only valid if profit margins are mean reverting over relatively short periods of time, such as 10 years or so, and this has not been the case in Japan.) This does not mean that they cannot be valued by other means. In this and the next blog I attempt one possible way to do this.
The eurozone’s economy appears to have stalled. It was widely expected that growth would pick up to 1 per cent this year, but these estimates are now being toned down as the first two quarters of 2014 have been below expectations. The pattern shown in chart one (below) is, at best, one of stagnation. It is therefore agreed with near unanimity that the eurozone’s economy needs a boost.
It is generally agreed that the stock market dislikes falling profits and rising interest rates and that the two in combination are particularly to be feared. History supports this. According to my rough calculations, the stock market has declined 29 per cent of the time since 1947, but 40 per cent when falling profits and rising interest rates have coincided. Fortunately for investors, such conditions are relatively rare, as 75 per cent of the time the impact of rising rates has been offset by higher profits.
In a recent blog I argued that the risk of a negative combination of interest rates and profits is unusually high. Profits tend to be boosted by falls in personal savings, which have now fallen to a low level and this support is now less likely. Since 1947 increases in interest rates have been accompanied by rising profits in 23 years; in all but six of these years personal savings have fallen. History, therefore, suggests that the decline in savings has been very important in reducing the risks of the damaging coincidence of rising rates and falling profits.
In my previous post I showed why it seems likely that profits published by US companies are currently overstated by much more than they have been in the past. This does not necessarily mean that the degree of overvaluation of the stock market shown by cyclically adjusted price-earnings ratios is understated. The profits as published have been far more volatile than shown in the national accounts, and it is probable that published profits were heavily understated in 2008, as earnings per share in Q4 2008 were negative, while those shown in NIPA Table 1.14 remained strongly positive.
The profits published by US companies are defined in a very different way from those published in the National Accounts (NIPA Table 1.14) and in recent years they have increasingly diverged.
Those published by companies have become even less “honest” than they used to be. This is the result of the much greater incentives for management to alternately over- and understate the “true” profits, and the much greater ability to do so.
The massive rise in bonuses paid to managements, which depend on the data the companies publish, has encouraged companies to boost profits in the short-term as bonuses often depend on short-term changes in earnings per share or return on equity. Even when they are more directly related to changes in share prices, these often respond to similar changes in the published data. Parallel with this rise in incentives to misrepresent profits has been an increasing ability to do so, with the change from “marked to cost” to “marked to market” accounting.
Asset prices fall if investors’ liquidity preference rises or if their liquidity falls (ie, if investors need the money or want to have more cash in their portfolios). Liquidity depends on central banks; they can create it or soak it up. The US Federal Reserve seems unlikely to reduce liquidity unless inflation picks up, but is likely to stop creating it in October. Therefore, one way in which asset prices will fall is a rise in inflation or pre-emptive action by the Fed to stop it.
When the Fed creates liquidity, it takes a larger rise in liquidity preference than before to hit asset prices. The Fed is thus in the process of increasing the market’s sensitivity to rises in liquidity preference and, as small changes are the normal response of investors to new information, the volatility of the market is therefore likely to rise. In the absence of increased interest rates, large changes in liquidity preference, however, are likely to depend on falling profits.
According to an article in The Economist on August 2, “economists trying to explain the feeble pace of America’s recovery regularly blame deleveraging”. This raises two questions: can the US recovery sensibly be described as feeble and, if it can, is deleveraging to blame?