When university students enter into the study of economics, they generally take first year courses in Micro-economics and Macro-economics. Macro looks at the whole economy and the mechanisms that governments use to affect it. Micro looks at how businesses operate. If Macro is the forest, Micro is the trees. At the moment, Micro and Macro are telling very different stories about what is going on in the real economy, particularly in the United States. As the largest economy in the world, what happens there affects all countries, and especially Canada, which continues to send about 70% of its exports to our American neighbors.
There is no question that the macroeconomic environment in the United States is shaky. Unemployment remains high, housing prices are stagnant at low levels and growth is weak. Steps taken this week by the U.S. congress to cut spending by Government will not help, and in fact may raise further impediments to growth by removing some of the stimulus which has helped the economy recover from the deep recession of 2008/09. Consumer spending, which accounts for about 70% of economic activity in the U.S., actually fell in June, although only very slightly. In short, we have not seen the buoyant rebound from the lows of 2008/09 which had been hoped for.
Yet while this is going on, American companies are earning record profits. The 500 biggest public companies in the U.S. which together comprise the S&P 500 will report record profits for the 2nd quarter of 2011, following the (then) record profits of the first quarter. For all of 2011, it is likely that these giant companies will have combined profits of almost $100 per share. How is it that corporate America can be doing so well when the economy as a whole is tepid at best?
There are a number of reasons. During the recession many companies cut payrolls. As business has improved, they have been very slow to rehire laid off workers. In short, they are doing more with fewer workers. The record low interest rates which remain in place have also allowed companies to borrow at low rates and invest in equipment that improves productivity. From industrial robots to better computers, companies are using technology to improve efficiency, and the benefits flow to the bottom line. A weaker American dollar has resulted in higher profits for multi-national firms. Earnings from abroad translate into higher dollar amounts, boosting results. Finally, low tax rates on corporate earnings and generous write-offs and loop holes have allowed major companies to pay less to the government and more to shareholders.
The terrific profits of the major companies have not been reflected in the stock markets. Macroeconomic events, the U.S. debt ceiling crisis, the problems in the Eurozone and the size of the U.S. public debt have hogged the headlines, allowing the corporate profit surge to go mostly unnoticed. The S&P 500 Index is currently trading at about 1,250, or about 12.5 times profits. Over the past sixty-five years, the price to earnings ratio for the S&P 500 has averaged about 16 times earnings. To reach just the average level, the S&P would have to go up by 28%.
One thing that companies do with profits is pay dividends to their shareholders. This year the 500 S&P companies will pay dividends of about $25 per share in total, a yield of just about 2%. Not a very high return in an absolute sense, but when compared to the interest rate returns available to investors, not so bad. An investor who purchases a 5 year US government bond will receive interest of 1.25% per year; but unlike dividends, the interest paid on bonds does not go up, and the bond itself will not rise in value (if held until maturity). In contrast, profitable companies raise their dividends regularly, so the income from stocks rises every year.
It is not so surprising that the stock markets all over the world have taken a hard hit in the past three weeks or so. The debt ceiling crisis in the U.S. did little to raise confidence in the governance and wisdom of the most important country in the world. Recent economic data has only raised the level of anxiety and has revived talk of a double dip recession.
We do not expect another recession, and while we do have concerns about the course of economic policy in the U.S., we remain encouraged by what we see in corporate earnings. We continue to believe that investors who purchase high quality companies which make profits and pay dividends will be rewarded over time. This is even more true when the company shares are available at bargain prices. While the forest is getting the headlines, we are looking at the trees.