The first three months of 2012 marked the highest first-quarter return for the S&P 500 index since 1998 with a total return of 12.6%. The best performing sectors were Financials (21.5%), Information Technology (21.1%) and Consumer Discretionary (15.5%). The Utilities sector was the only index component delivering a negative return for the quarter, losing 2.7%.1
The rebound in corporate profits continues to expand from the nadir of three years ago with profit margins at a record post-war high for U.S. corporations.2 It is often difficult for the person on the street to reconcile the continued strength in the stock market with the low GDP growth, high unemployment and falling home prices of the “new normal” economy experienced over these past three years. How can corporations (and their common stock prices) be doing so well when the rest of the economy seems so stagnant? There is no single factor that can account for this phenomenon, but several observations may help to explain our current experience.
Corporate revenues and expenses are global. Over the past 30 years, corporations have been selling more of their products and services outside of the U.S. where GDP growth rates are much higher and wages are considerably lower. This has allowed corporations to grow revenue faster than input costs with wages being the main component of expenses. Wages have risen in developing countries over this time period while they have experienced little or no growth in the developed world.3
Unlike consumers and financial firms, most corporations in the U.S. were not highly leveraged on the eve of the Great Recession. Corporate balance sheets were in good shape, allowing companies to take advantage of lower borrowing costs when interest rates plummeted.4
The Great Recession accelerated the evolutionary process for corporations. When revenues fell in 2007 and 2008, non-financial corporations acted quickly to maintain profits by eliminating workers and closing factories. Revenues have grown in the last three years, but corporations have been slow to hire over this time period. Revenue per employee was 10% higher in 2011 than in 2007, a clear demonstration that corporations have been able to grow sales without a commensurate increase in wages. Corporations have used their record profits to increase dividend payments for shareholders, repurchase common stock, invest in capital equipment and buy other companies. These activities have reinforced the dominance and profitability of the survivors under circumstances that have weakened or eliminated their competition.5
Sources: 1 – Standard & Poor’s: standardandpoors.com, 2 – Montier, James, GMO Whitepaper – What Goes Up Must Come Down: gmo.com, 3 – U.S. Bureau of Economic Analysis: bea.gov, 4 – Federal Reserve Flow of Funds: federalreserve.gov/releases/z1/, 5 – For Big Companies, Life Is Good – April 9, 2012, Wall Street Journal: wsj.com