2023-05-31 08:30:00 ET
Summary
- Rather than from an unprecedented increase in greed, corporate profit margins mainly increased during the pandemic due to lower interest rates, taxes, and fiscal stimulus.
- Profit margins have fluctuated in the post-WW2 era and are currently at the high end of their range, mainly due to lower interest and tax expense.
- Analysts may be overestimating the impact of technology on profit margins and underestimating the effects of taxes and interest rates.
- This is likely to negatively affect future P/E multiples for mega-cap stocks.
The point is, ladies and gentleman, that greed -- for lack of a better word -- is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms -- greed for life, for money, for love, knowledge -- has marked the upward surge of mankind. And greed -- you mark my words -- will not only save Teldar Paper, but that other malfunctioning corporation called the USA.
-Gordon Gekko, Wall Street (1987)
The 1987 classic Wall Street follows stockbroker Bud Fox (played by a young Charlie Sheen) and corporate raider Gordon Gekko (Michael Douglas) through their rapid rise and fall. The most famous scene in the movie, however, is the speech Gekko gives at the annual shareholder meeting of Teldar Paper, a struggling paper company. Gekko admits and embraces his greed, and counterargues that the overpaid, complacent management of the company is the real problem. Nearly 40 years later, the debate is as relevant as ever. The New York Times popularized the term "greedflation" in 2022, exploring the idea that some or all of the recent bout of inflation has been caused by corporate greed. Initially thought to be the economic equivalent of astrology, the idea has picked up some traction with recent research indicating that monopolistic companies have profited from inflation. The WSJ recently ran a piece arguing that greed is good and that greed is helping the economy stay out of recession. Even the Fed is taking the idea seriously, with Minneapolis Fed president Neel Kashkari weighing in on the topic in a recent interview with New York Magazine . So why are profit margins higher than usual, and will they stay that way? Is greed causing inflation? Or are these all just political talking points?
"Before You Ask Why, Ask If": A Look at Corporate Profit Margins
First, before we evaluate the claim that companies are using monopoly power to increase their profit margins, we should look at whether profit margins have increased, and by how much.
First: a longer-term view . On the left are corporate profit margins as a percentage of GDP, and on the right is employee compensation as a percentage of GDP. Note that this graph ends in early 2022, while the one I'll share below this will include the more recent trends.
This indicates that corporate profit margins indeed have increased in recent decades, but they were also high in the early post-WW2 era. As you can see here, corporate profit margins tend to ebb and flow, with the lowest numbers in the post-war era around 7%, and the highest around 12-13%. There are two hidden variables here that are incredibly important, and those are interest rates and corporate taxes. Low-interest rates cause profit margins to rise, as do tax cuts. The lower rates and taxes are, the higher you can expect profit margins to be. Rising rates and tax hikes cause the opposite effect.
Now, for an updated view, including 2023 :
Here, we see that profit margins peaked sometime in early 2022 and have actually shrunk quite rapidly in the time since, back towards historical norms. I expect this to continue. It's not shown directly here, but corporate profit margins in 2022 were helped greatly by the energy crisis, while most companies had no need to issue new corporate debt after loading up in 2021. Without energy profits being up, 2022 would have seen profits fall, not rise. Unless oil and gas prices surge again, this will put downward pressure on overall margins.
Forward analyst estimates, however, are indicating margin expansion. I think this assumption is highly dubious.
This ties in with the "pivot" narrative that the Fed will unleash an avalanche of liquidity to help bail out NASDAQ ( QQQ ) traders, as well as the "AI" narrative that tech companies are about to fire all their employees and rake in unprecedented profits. However, I think you can see a pretty clear trend here– large increases in profit margins were caused by ZIRP, QE, stimulus money, and government regulation suppressing competition (i.e. trade wars/COVID lockdowns). And of course, the government handing out stimulus money served to goose profit margins as well. When you're spending someone else's money, you're never going to be as sensitive to price!
To this point, there actually is a wealth of data from researchers at the Fed that directly shows that most of the increase in profit margins in the 21st century has been caused by two factors:
- Cutting the federal corporate tax rate from 35% to 21%.
- Zero rate Fed policy and QE.
We can do some quick algebra on this to estimate EBIT margins for companies 20 years ago and now.
Let's ballpark profit margins in the late 1990s and early 2000s at 8%, but add back tax and interest cost of about 48%. That gets us an EBIT margin of about 15.4%. Now, with margins at about 12% and adding back interest/tax cost of about 28%, we get an EBIT margin of about 16.6%. That's a bit higher, but well within the normal range of fluctuations, and it shows that there hasn't been a massive shift in the underlying profitability of Corporate America.
Rather, the main driver has been tax cuts and lower interest rates. This is a warning in disguise for those loading up on NASDAQ stocks thinking that Chat GPT is about to remake the economy in the next 12 months. Higher rates and taxes can easily swamp underlying changes in productivity. 21st-century technology has not yet led to big changes in margins. If anything, many mega-cap tech companies have bloated payrolls, and it shows in their stock-based compensation expenses. In truth, much of Big Tech today isn't actually so different than the 33 overpaid vice presidents at the fictional Teldar paper that Gekko went to war with.
Is Greed Causing Inflation
Generally no, greed isn't the main cause of inflation. However, companies in certain sectors of the economy have been able to get away with runaway price increases. These began before the pandemic, but when inflation got started these areas in the economy became bottlenecks that led to huge shortages and huge profits for companies with oligopoly power. I can think of a few examples:
- Companies in certain areas of the economy have used new technology to engage in monopolistic behavior. It's still old-fashioned price fixing, just by another name. Dozens of lawsuits have been filed against Texas-based RealPage for allegedly conspiring to fix apartment rental prices across the United States. The Department of Justice is also reportedly investigating . Economic theory will tell you that weak oligopoly power eventually cracks, and we're now seeing a boom in multifamily housing construction to make up for what were likely some artificial shortages.
- Antitrust enforcement in the US is notably weak, and it negatively affects consumers. For example, Arkansas-based Tyson Foods ( TSN ) cornered much of the US poultry market and has been accused of artificially restricting the supply of poultry to drive up prices. "Big Meat" has been involved in plenty of class-action lawsuits as well, and has drawn heavy criticism from the White House. As powerful as Tyson is, they aren't immune to the laws of economics, recently swinging to a loss as many consumers responded to higher prices by shifting their diets away from meat. The EU does a better job at encouraging competition than the US does, and you can see for yourself if you travel there. The higher quality meat and produce typically available in Western Europe is something that tends to shock Americans who travel there for the first time. The recent inflation in the EU is fairly easy to explain by the war nearby, but you need to dig deeper on inflation in the US to find causes.
- Perhaps the most famous cartel of all is OPEC+ , which is a cartel of oil-producing countries including Saudi Arabia, Venezuela, and Russia. After the world began to recover from the pandemic and Russia launched its invasion of Ukraine, oil producers held back on supply, driving prices skyward. Now, prices are starting to come down as the market encourages production to come out of the woodwork. Again, economic theory and practice show that unless you have a total monopoly over production, there are limits to how much profit you can extract from a cartel. Politicians love to complain about oil company profit margins, but domestic oil companies actually serve to reduce the amount of monopoly power in the oil market and decrease profits for OPEC. While oil companies like Exxon ( XOM ) and Chevron ( CVX ) benefit from higher oil prices, they're not capable of causing them.
Key Takeaways
- Profit margins did increase during the pandemic. Most of this was caused by a decrease in interest rates and taxes and fiscal stimulus.
- Profit margins have ebbed and flowed in the post-war era, and are currently sitting at the high end of their range. Again, this is easily shown to be related to lower interest and tax expense.
- An increase in greed is likely not to blame for increased profit margins, at least not in the long run.
- Profit margins have fallen quite rapidly off of COVID highs, and I expect this to continue. Analysts that think that Corporate America is fundamentally more profitable now than in prior decades are overestimating how much of this was caused by technology and underestimating how much was caused by taxes and rates.
- After considering the true drivers of margin expansion over the past 20-25 years, I don't see a coming boom in profit margins that would justify current valuations for mega-cap stocks. With cash rates soon to be near 6%, I believe there's a compelling case for shifting money out of stocks, particularly mega-caps.
For further details see:
Has 'Greedflation' Caused Corporate Profits To Increase? What You Should Know