Mike Panzner passes along this intriguing chart:
Not only are corporate profits at unsustainable 40-year
highs relative to GDP, cash flow has been falling while profits have been rising
in recent years — not a very sustainable situation.
Source: Michael Panzner
I believe the technical term for this formation on a chart is called ‘The Wheels Are Coming Off!’, indicator.
The Collapse of Managed Markets
Stocks Rally As Collapse Nears
“The stock market surged upwards upon hearing the
US Federal Reserve may cut interest rates to save
the economy. This is tantamount to heroin addicts
rejoicing their morphine will be increased because
doctors are concerned about their rapidly failing
health.”
An appropriate quote.
Does anyone know what the historical average is? From eyeballing the chart, it appears to be 7-7.5%.
It’s clear that for many corporations, it does in fact matter greatly that the market is now more global, and less protected than in the past (in aggregate). So….there is more potential competition, but also, the advantage of size is amplified.
What’s the obvious implication?
One answer:
For some length of time, large agressive corporations can have considerable growth and better economy of scale than in the past.
What is the length of time. Well, as it is influenced by many factors, we don’t know. But one primary factor is the ramping of wealth in Asia leading to increased demand over decades of time.
“Cash flow” in this chart means….operating cash flow, or free cash flow?
@Marcus Aurelius
Saying “the wheels are coming off” based on this chart alone is being a little alarmist IMO.
It looks like the two lines move together almost everywhere on the chart until the last 2-3 years.
Wunsacon,
Quite so. This graph shows cashflow vs profits on a YoY % basis. It’s pretty clear that profits are running ahead of cashflows, and that this isn’t a normal state of affairs.
It’s also notable that overshoots (CP over CF) tend to be followed within a year or two by undershoots (CP under a much reduced CF).
This suggests overshoots may be indicative of diminishing quality of earnings. The notion of booking profits on a yield-to-maturity basis while collecting only a lower teaser rate comes to mind as an example of low quality earnings. I’m not sure enough of the calculation details of the corporate net cash flow measure to be certain that’s captured in the way I think though.
Anyone else know?
I presume this cash flow figure is after stock buybacks. Buyback activity has been at record levels and could account for some of the decline in cash flow.
My guess is the same as David’s as in the last two years cheap money gets used to fuel buybacks that take the place of an actual business plan that outlines organic and non-organic growth with the non-organic route being the preference of actually having to work to grow a business.
“you mean we actually have to do something?”
CEO’s take the lazy, short term buyback (that in some cases does’nt even happen)route (look at HD,AMZN,HOG to name but a few ill-advised usages of now-precious cash) so that they keep the BOD happy and continue on for yet another year.
At this point growth sucks and it will not be fueled by the % of buy backs we’ve seen.
Can I offer a topic for discussion? Similarities/Differences between a GSE (Fannie and Freddie) and a SIV.
Similarities:
– Both borrow short and lend long.
– Both own highly correlated securities with inadequate hedges.
– Both are highly levered.
– Both have the “guarentee” of a financial backer (large investment bank or Government).
– Both are opaque and require faith in security valuation.
Differences:
– A GSE can raise additional (dilutive) capital at attractive rates.
– Um. Hmmm… Other differences?
@Marcus Aurelius
Saying “the wheels are coming off” based on this chart alone is being a little alarmist IMO.
Posted by: Adam | Dec 3, 2007 12:59:02 PM
_________
Okay. Use any recent chart you like. I wasn’t being alarmist (well, the exclamation mark didn’t help) – just making an observation.
I happen to believe that the markets are going to crash in a way that would make our grandparents and great-grandparents wince. That’s not to say I think anyone should be alarmed.
but we all can “hope” right??
Just ask Hanky-Poo as he’s got it down to a science…….not sure what that is but we all have “hope”
Ciao
MS
It looks like the most recent measurement was cash flow = 0.09 and profit = ~0.11. How can profits be higher than cash flow? It looks like this has happened before on the peaks.
Look at the 0.08 level on both measures – cash flow row above this in the 70s, and has not been below it since. Profit on the other hand, fell below this a few years before, and has only occasionally touched this level until a short trip above in the 90s and the recent moon shot.
TED spread hit highest level since Oct 1987 today.
Smokefoot,
A company reporting net income higher than cash flow is not all that uncommon. One way, as an example, is when book tax (GAAP) is higher than IRS taxable income due to certain tax credits. In this case a company will build up a deferred tax liability that may need to be paid to the IRS at some point in the future. Even though profits maybe at a certain level in a given year, a company may have payment of large deferred tax liabilities (use of cash) with said tax not associated with current year income. This is one way NI can be higher than cash flow. A large build up in accounts receivable (lower A/R turnover, a use of cash) can also result in cash flow being lower than NI.
When evaluating companies, NI is only a small part of the health of a company…cash flow is what pays you back. This is one reason dividend growth companies are an attractive foundation of an investment portfolio. The dividend is CASH.
Hope this helps.
I would be curious to see how much of this gap is due to Accounts Receivable and Inventory increases – the bringing of future expected profits onto current balance sheets would make some sense if you believed the party would keep going – but when the party stops, there are writeoffs and writedowns with which to deal.
It would also be interesting to see if (as I expect) loss provisions during the same time period had been reduced on a percentage basis.
Looks like another case of reversion to mean is building steam.
@ Marcus Aurelius/Adam
Personally, when I read the “wheels coming off” bit, the first thing I did was fall over backwards in my Aeron laughing.
Then I posted the Aeron on Craigslist.
S&P500 buybacks in 2006 were $432B. Total company buybacks in 2002 were about $100B. Of a $13T economy, that’s an increase of about 2.5%.
What is the scale on the right? Is that the ratio of cashflow/GDP? If so, then the drop-off in the past 2-3 years of around .025 (2.5%) approximates the buybacks.
I didn’t consider buybacks outside the S&P500. But, those companies by definition won’t be buying back as much market cap.
So, maybe:
– Earnings quality isn’t bad.
– While the earnings probably won’t continue rising the way they have, the drop-off in cash flow isn’t indicative of some structural problem.
look at the time frame on this chart – by the looks of it – the red arrows start at about 2003, when this bull began. How can you trade on this? By the looks of it, corporate profits peaked around 97 maybe? And cashflow peaked around 03? If you used these signals you missed a lot. This scale is too large to use. I also love the obligatory, just because its high its “unsustainable” comment.
Chad wrote, “How can you trade on this?”
I don’t think you can. What it shows me is that for around 47 years there has been a strong correlation between earnings and cash flows, but for the last 3 years or so there has been a divergence – divergences are almost always meaningful and usually result in mean reversion – the power of which should never be underestimated. To ignore the data is to believe that somehow after 50 years it is “different this time”. I doubt that is so – but I do not know when the expected mean reversion will occur.
Data of this sort should not be assumed to be a timing device. Like a new high/new low index, the value is in registering growing divergence warnings in time to take safeguards.
A couple of points of clarification. First, those charts are from the nat’l income data tables which you can look up for yourself on the STL Fed site and graph if you like. Cash Flow as they report it isn’t what we normally think of as corporate cash flow but is close. It tends to map Corporate Profits pretty closely however. It’s well worth looking at as well as comparing the two measures on both an absolute and YoY basis. To get them as % of GDP however you have to dload the data and do some spreadsheeting exercises. Since the data run back to ’47 you can get a wonderful feel for the structural shifts in the economy.
To an earlier comment btw the average of corporate profits is about 9.5% but the trends over time are really important. While I’ve not update the charts to reflect the latest data the analysis remains the same and a dissection of those trends is here:
Dr. Pangloss Treating Goldie: Markets, Profits & Earnings: http://tinyurl.com/2j297q
A separate, and more important point in my mind, is that profits & earnings are not driven by organic business growth in revenues, profits or bottomline earnings but by EPS growth based largely on buybacks.
If you look at long-term PE ratios for the SP500 you get a feel for how much Mr. Market has inadvertently grasped that point with the enormous rise in EPS combined with a counter-balancing compression of PEs. This DOES NOT bode well for the outlook.
If you’d care to dig into the non-organic nature of profits, earnings and EPS try this – Review the Bidding, Count the Cards: EPS Growth Rates: http://tinyurl.com/2bbumt
And an earlier discussion of the huge impact of buybacks and their relative impact is here: Market Drivers 3 – Buybacks: http://tinyurl.com/2ekttb
I’m getting flashbacks to Lucent and Enron.
there are several reasons this can happen.
– growing inventory levels (increases in working capital)
– increased write-offs/write-downs (corporate impairment)
– increased capital expenditure relative to depreciation and amortization (meaning you had to spend more to replace what
– accelerating depreciation and amortization
– share buybacks (OK if for the right reasons [as a proxy for dividend payments when the stock price is trading below intrinsic[fair] value], not OK if it’s for bad employee-stock-option plans)
none of these is a very good sign, unless in the case of inventory increases and greater growth capex investment you’re anticipating increases in future demand.
do you see increases in future demand in this economy?
This may be too late to be seen but anyway…
Does the profit measure include overseas earnings? If so, is GDP the relevant denominator – rather, GNP?
Likewise, cashflow?
Ta
not a so good sign of the health of the economy.
A perfect example of information that is likely to be completely accurate and totally useless. Content designed to fuel negative thinking.
There are a huge number of successes happening in any economy. There are a huge number of turnarounds in any economy. What are those businesses doing?
In my experience following the approach of having a clearly established performance goals with well defined action steps works very well. Of course assign clear accountability for the action steps and measure actual vs. plan on a timetable that makes sense as to what you are monitoring. Cash for example may be monitored daily.
We can manage the business or use the excuses it is the economy or the dollar, foreighn competition etc. Companies need to stop making excuses.
Steve Pohlit
http://www.stevereports.com