To Infinity and Beyond — Corporate Profits Beating Global GDP Growth

Around this time last year, I began to suspect that the billionaires knew something we didn’t. They’re not different from us. That is, they’re not, so far as we know, aliens. They DO have a lot more money, though. But why are they all trying to get off this planet as quickly as they can?

I’m referring to Jeff Bezos, Richard Branson, and Elon Musk. And in that three-horse race, Branson took the honours on Sunday. The VSS Unity took off from a spaceport (that’s a thing now) in New Mexico at 8:42 am. Less than an hour later, Branson, three other passengers, and two pilots were 57 miles above the Earth.

You, too, can enjoy the change in perspective that comes from going to space, now that Virgin Galactic is up and flying. The company says it already has 600 reservations booked at the bargain-basement price of US$250,000 per trip. Later this month, Bezos himself will go ad astra when Blue Origin takes its maiden commercial flight. An unnamed passenger has reportedly paid US$28 million for a seat on that flight.

You probably have a better chance of getting on one of those flights than you do getting out of, or into, Australia right now. With Victoria’s Daniel Andrews closing the border to New South Wales earlier today, you’ll need more than a valid permit to travel around your own country. Tickets to space, at least, are for sale.

I’ll come back to Australia’s increasingly dystopian, draconian, and authoritarian pandemic response in a second. But first, to ground our financial discussion in some valuation reality, a few numbers. First, the price-to-sales ratio on the S&P 500 has reached an all-time high of 3.21 times (as of Friday’s US close). The average since 1990 is 1.5 times sales. It’s well above the five-year average of 2.26 times.

S&P 500: To infinity and beyond!


S&P 500: To infinity and beyond

Source: Bloomberg

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Here’s a question for you: How long can corporate profits continue to grow faster than global GDP?

Corporations have to justify these valuations. By that, I mean for these ratios (price-to-sales, price-to-earnings, price-to-book) to be anything other than indicators of a colossal bubble. The growth in corporate profits will have to outpace sub-standard global GDP growth. How likely do you think that is?

Maybe if we all take rocket ships to Mars and start building a new colony there, we could achieve that kind of growth. After all, future growth has always been tied to the opening of new worlds — the New World of the Americas in the 17th, 18th, and 19th centuries. Then the New World of the old communist world, starting in 1989 with the fall of the Berlin Wall and in 2000 with China’s joining of the World Trade Organisation.

Liberating several billion people from the tyranny of one-party police states with a planned economy and ruthless political extinction of ideological opponents turned out to be good for the planet, at least in GDP terms. There was plenty of growth to be had. Freedom and prosperity go well together. And plenty of new credit, globalisation, and automation led to an expansion in corporate profits (at least as valued by the stock market).

The whole system nearly came crashing down since 2008 with the Global Financial Crisis. But since then, central banks in the US, Japan, England, and the European Union have increased the size of their balance sheets by over six times, purchasing a hodgepodge of government bonds, corporate bonds, and even exchange traded funds (in Japan) worth more than US$24 trillion.

The result is the aforementioned blowout in traditional valuation metrics for stocks. Let’s take another backward-looking metric, Tobin’s Q ratio. The Q ratio divides the market value of a company by the replacement cost of a company’s assets. The higher the ratio, historically speaking, the more overvalued a company. See below:


1Q21

Source: Fed

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Looking backward again, in the first quarter of this year, Tobin’s Q ratio surpassed its previous all-time high in the first quarter of 2000. In March of 2000 that the Nasdaq Composite — the epicentre of the dotcom bubble — peaked. And now? And now the Nasdaq and the S&P 500 have made new all-time highs as the Q ratio makes its new high.

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This time is different, of course. In today’s new world, it doesn’t take capital investment in property, plant, and equipment to generate earnings and profits. That’s passé. The highest returns on investment are generated by intangible capital, ideas that change the world. A company’s market value relative to the replacement cost of mere tangible assets doesn’t tell you anything about its REAL future value, does it?

Or does it? Hold that thought. And take a look at Robert Shiller’s Cyclically Adjusted Price Earnings Ratio (CAPE). Shiller’s ratio smooths out the volatility in earnings by adjusting them for inflation over a 10-year period. The highest it’s ever been is 44.19, in December of 1999. Friday’s level is the second highest it’s ever been.

How high is too high? We’ll find out. On a valuation basis, relative to underlying earnings and profits, stocks can go as high as they want, as long as ‘investors’ keep paying a premium for them. Value is in the exchange, as Bastiat said. And if buyers find ‘value’ in stocks at these prices, the price is the price.

But there IS an underlying law of economic gravity at play here. Companies can’t infinitely grow earnings faster than GDP growth. You can cut costs (lower wages through automation). And you can increase sales and profits (new markets, new products, new customers, new frontiers). But you can’t do so forever.

Sooner or later, competition or gravity or debt will catch up with you. This is what happens in a normal business cycle. You get booms and busts, manias, panics, crashes….periods of intense fear….and periods of intense euphoria and greed. To everything, there is a season.

So now we turn to whether the glorious future of billionaire space travel justifies the pedestrian present of record valuations. It does not. Only liquidity makes it possible. Free central bank money (low interest rates and quantitative easing) has been rocket fuel for financial assets. They’ve flown mighty high.

The trouble with financial markets is that they’re not rocket ships. They don’t return to Earth in an organised re-entry, with a slow descent to a safe landing. Thank you for travelling. Please come again.

They crash. And burn. And typically, the biggest casualties are the passengers who got on board at the last second, afraid of missing out on all the excitement.

Be very afraid. But not of missing out. Of crashing back to Earth and reality. This brings me back to the Lucky country.

One thing I learned in my 10 years living in Australia (before coming to love it and becoming a citizen) is that most people don’t realise the ‘Lucky Country’ moniker is incomplete. It had a much darker meaning. The phrase came from Donald Horne’s 1964 book by the same name. And here is the original context in its entirety:

Australia is a lucky country run mainly by second rate people who share its luck. It lives on other people’s ideas, and, although its ordinary people are adaptable, most of its leaders (in all fields) so lack curiosity about the events that surround them that they are often taken by surprise.

Australia, like the US, is lucky in its geography. The US had continental wealth available for the taking, provided you were willing to head West, risk your life, and take it from anyone who might have already been there. Australia has golden soil and wealth for toil and is, like the US, girt by sea. There was a fair bit of ‘taking’ from the natives as well.

Other than the big scare with Japan in the Second World War, being invaded by a foreign conqueror has never been a serious threat (at least not a military invasion) for Australia. Both Australia and the US inherited English common law. And although the US adapted that legal tradition by getting rid of an English Monarch in 1776 and making the people Constitutionally sovereign, both countries basically valued the same things: private property, individual liberty, the Rule of Law, and sound money.

Australia’s current political leaders, at the state and national levels, have complete contempt for individual liberty and the Rule of Law. They’ve behaved shamefully, ignorantly, or with wilful destruction of the kind of private rights and liberties that characterise a free society. And it’s only getting worse.

It will take a new political rebellion and a new generation of leadership for Australia to recover from the damage done by this incompetent lot during this perpetual emergency. No one ever said navigating a global pandemic was going to be easy. But to be worse off, 18 months into it, with the only solution being the failed route of MORE lockdowns and less liberty, takes some doing.

No one would blame you for wanting to get on a rocket ship at this point or getting in the car and making a run for the border. But in lieu of those things — which are either too expensive or too late to do now — we suggest you do the ONE thing you can do — make sure your retirement and your money don’t get destroyed at the same time.

Regards,

Dan Denning Signature

Dan Denning,
Editor, The Rum Rebellion

PS: The Rum Rebellion is a fantastic place to start your investment journey. We talk about the big trends driving the Australian Economy. Learn all about it here.


Dan Denning is the co-author of The Bonner-Denning Letter.

Dan was a founder of Port Phillip Publishing back in 2005, which quickly became the leading publisher of its kind for independent financial research and insights. In 2014 he left to head up Southbank Investment Research in the UK. Dan is also the author of the 2005 book, The Bull Hunter. Today, he’s based in his home state of Colorado. Each Monday in The Rum Rebellion you’ll get Dan’s unique contrarian thinking to provide insights you won’t find anywhere else.

Dan Denning’s belief in free markets, sound money, personal liberty, and small government have underpinned everything he’s done during his 23 years in the financial publishing industry.


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