The Jenga Metaphor - Analyst Blog

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The single most important thing for stocks are profits. The second most important thing is interest rates. That is because the "true value" of any stock is the value of all the cash flow it will generate from now until the Pacific Ocean boils dry, discounted back to the present.

While from quarter to quarter reported earnings can be gamed -- and thus it is important to look at the quality of earnings -- that is more of an issue at the individual-company level than for the market or the economy overall. Reported earnings take into consideration things like the fact that machinery wears out and has to eventually be replaced.

Ideally, reported earnings and economic earnings would be the same thing. As it stands, reported earnings are simply the best proxy for true economic earnings we have. If a companies earnings go up, then over time, that companies stock price will rise. If corporate profits rise for the economy as a whole, then the market should rise.

Profits Remain Healthy

As far as the economy is concerned, corporate profits are doing great. For example, based on the collected wisdom of all the analysts covering the 500 firms in the S&P 500, the index will report total net income of over $1 Trillion for the very first time ever. However, those companies earn a lot of their profits overseas, and there are far more than 500 companies in the U.S.

The government does, however, keep tabs on the total level of corporate profits in the U.S. and it tells much the same story. The higher corporate profits (after tax) go, the higher the market should go.

However, what happens when those profits are coming at the expense of the vast majority of people in the country? Ultimately, companies have to sell goods and services to stay in business. For that to happen, their customers have to have money (or at least the ability to take on debt) to pay for those goods and services.

Explaining the Jenga Metaphor

What you have then is sort of like the party game of Jenga. In that game, you stack three wooden blocks going one way, then three blocks at a 90 degree angle to those, and form a tower. The object of the game is to pull out one of the lower blocks and put it on top, thus building the tower higher and higher. The problem is that the base is becoming more unstable as the blocks are pulled away and the tower gets top heavy. The game ends when the tower collapses.

That is exactly the process that we have been seeing going on in this country. Since the start of 1959 when the government started keeping track, wages and salaries have averaged 48.42% of the economy. In the third quarter of 2011, they hit a record low of 43.75% of GDP. Over the same period, corporate profits have averaged 5.99% of GDP, and in the third quarter they hit 9.92% of GDP, just off the record high of 10.29% set in the first quarter of 2006.

Even those comparisons understate what has been happening. If you look at the average levels through then end of the century, they were 5.48% for profits and 49.14% for wages.

Prior to 2000, profits were above 6.0% of GDP in just 34.1% of the quarters, and wages were below 49% in 50.6% of the quarters. Since then, corporate profits have been more than 6% of GDP in 32 of 47 quarters, or 68.1% of the time. Wages have been above 49% of GDP in every quarter but one, or 97.9% of the time.

If somewhat different break points are used, the difference is even more startling. In the 20th century (starting in 1959) corporate profits were above 7% in just 3.7% of the quarters, since them they have been over that level in 63.8% of the quarters. Wages were below 47% of GDP in just 19.5% of the earlier period quarters, and below that level in 78.7% of 21st century quarters. The graph below shows the path of both as a share of GDP.

It is nice to see the tower climb higher, to see corporate profits rise. We all like to see the stock market go higher. Third quarter 2011 was once again an excellent one for corporate profit growth, and inside the S&P 500, positive earnings surprises outnumbered disappointments by almost three to one. The strong earnings picture is without question the number-one argument in the bulls' favor.

The question is, how unstable have we made the base, and when will it collapse? Already the economy is suffering because of a lack of demand. People do not have money and thus are not spending. Businesses have responded by cutting costs, and significantly by cutting what they spend on wages and salaries, either though not hiring people, or by not giving raises.

With few customers, businesses have little incentive to invest to expand production. They do, however, have an incentive to invest in equipment that will cut costs further -- often by substitution capital for labor. A factory robot would be a great example of this.

Thus, spending on equipment and software has been one of bright spots of the recovery so far, while employment has been very slow to recover. I'm not saying that the collapse is going to happen tomorrow, just that the tower is starting to wobble a bit.

Zacks Investment Research

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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