Profit mean reversion and recession
Yesterday I retweeted an interesting tweet by Business Insider’s Henry Blodget which references an article on data compiled by Barclays on profit mean reversion and recession. The gist of the article is that a profits recession generally presages a real recession except perhaps to the degree the profit downturn is caused by the volatile oil sector. While I am not talking about recession yet, I do think we are seeing economic weakness toward the end of the business cycle. And while that doesn’t mean recession in the near-term, it could do in the medium-term. Thoughts below
Here’s the money chart by Barclays
We know from history that the dates when profits rolled over coincide very much with the slide into recession. My interpretation of these data is exactly as Barclays says, that you get enough of a slide in profits and it generally leads to recession. That is because the profits recession comes as a result of a weakening economy that has weakened so much that companies are no longer able to cut costs, buy back shares or massage accounting enough to keep profits rising.
The outlier of course is 1985, a date 3 years after a major and wrenching double dip recession, when the profits drought was caused by a decline in profits in the oil patch. The Barclays researcher Jonathan Glionna surmises that this recession didn’t lead to a recession “because lower oil prices are good for the economy”. This is where I differ from Barclays. Oil price declines are not good for the economy. They are good for consumers because it is a net transfer from producers to consumers. And they are good to the degree that it shifts income to agents with higher marginal propensities to consume. But oil price declines, severe declines, are wrenching experiences associated with massive job loss and capital expenditure reductions.
Think about what happened in the mid-1980s. The oil industry lost a whole generation of experienced middle managers to lead them into the next production phase. This, combined with another drop in oil prices and massive capital underinvestment eventually led to the merger wave in the late 1990s and early 2000s. Remember Penn Square Bank? Continental Illinois? That was the period leading up to 1985. If you asked anyone in banking who lived through that experience, I am sure you would hear them say that there was widespread fear that we were headed into a triple dip 1930s style depression. By the way, I have heard of similar fears from the 1973-74 recession and bear market. But the point here is to put the lie to the premise that oil price declines are unambiguously good for the economy. They aren’t. It all depends on how much damage is done to jobs and capital expenditure.
I would say that 1985 was a mid-cycle pause more because we had just escaped a double dip recession three years prior, and were in the midst of a massive decline in interest rates and inflation. These macro factors allowed the economy to power through despite the economic turmoil and bankruptcies.
What about today?
We are now in the seventh year of a cyclical recovery and bull market. Shares have tripled in that time frame. I would say this means we are much closer to the end of the business cycle than the beginning. Moreover, as Jeremy Grantham is quoted in the Business Insider piece, profits are mean-reverting and right now they are reverting from a phase that is “wildly optimistic” according to Warren Buffett. All of this is taking place against the backdrop of an economy in which wage growth is weak, household debt is still relatively high on a historic basis as a percentage of income and we have no policy room on the monetary side, with limited political appetite for policy on the fiscal side.
To me, the pre-conditions for this profits recession speak to downside risk, both for risk assets and for the real economy. None of the data speaks to recession in the real economy right now. We are seeing a slowing of job growth and likely of trend economic growth as well. But with a profits recession hitting, the potential for further downside is high.