Feeling bad, but still prosperous

The U.S. stock market, as measured by the S&P 500, has had an outstanding year so far, posting gains of 12.8 percent through August 10. Yet, there are plenty of reasons to feel pessimistic about the future: unemployment is at 8.3 percent, Europe continues to fumble for an answer to its debt crisis, and growth in emerging economies is slowing. How can stocks, which are supposed to trade on future earnings, be doing so well when the financial press is full of caution? We believe the answers to the apparent disconnect lie in the financial reports of U.S. companies for second quarter 2012.

For those watching closely, there has been a lot of good news for stocks. Of the companies in the S&P 500 that have reported second quarter earnings, more than 70 percent have beat Wall Street’s earnings estimates. That means that companies are making more money than analysts expected. As analysts adjust their future estimates to include the recent good news, prices of stocks rise. While earnings are surprising to the upside, revenue—or how much companies sell—has been surprising to the downside. Almost 60 percent of S&P 500 companies missed their Wall Street revenue targets. Companies are making more money than expected, but with fewer sales.

Companies are able to generate more profit per sale by controlling costs. Another way of putting this is that companies are squeezing more and more out of their employees; in economics parlance we call this productivity gains. Productivity gains are good, because it means that each employee produces more, which generally leads to higher wages and more disposable income. Higher disposable income in turn leads to more spending, which leads to higher revenue for companies. You get it—a virtuous cycle of growth. Yet while productivity is rising among those employed, we have a large pool of unemployed workers and that means that wages aren’t rising; try negotiating a raise when there are 3.5 job-seekers for every 1 job opening. Without rising wages, disposable income is stagnant, which means people aren’t buying more things, and that largely explains the missed revenue numbers.

The fact that we haven’t been able to enter the cycle of virtuous growth is part of the reason why the recovery has felt uninspiring. That said, even in this weak environment, companies continue to increase profitability as they squeeze workers for more output without increasing their wages. But, the current state can’t go on forever. Companies will eventually start hiring and that will result in higher wages. Either there will be virtuous growth OR companies will start to put up disappointing earnings. We don’t know which scenario will play out, but we are hoping, along with the rest of the country, for the former.

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