
Was corporate profit growth a bubble inflated by "financial engineering"? - timlangeman
https://www.openpolitics.com/2020/03/14/was-corporate-profit-growth-inflated-by-financial-engineering/
======
H8crilA
Yes. Aggregate corporate profits have not gone up at all:
[https://fred.stlouisfed.org/series/A053RC1Q027SBEA](https://fred.stlouisfed.org/series/A053RC1Q027SBEA)

There's a long way to go down to normalize this situation. I'm not saying this
will happen, but the downside potential is enormous.

Also, don't forget about the 50% of US GDP ($11T) that have been loaded into
US capital markets (both debt and equity) by foreigners. This is also hugely
out of balance:
[https://fred.stlouisfed.org/series/IIPUSNETIQ](https://fred.stlouisfed.org/series/IIPUSNETIQ)

~~~
eanzenberg
Profits don't (really) matter. If your revenue is growing 100% YOY, and your
profit is -10%, who cares? If your costs aren't growing as fast as your
revenue, then it's easy to turn a profit if you choose. Companies choose not
to because it hurts them long-term. They choose to grow and enter new markets
as fast as possible to get a foothold.

~~~
bulletsvshumans
Growth only matters to the degree that it will eventually lead to higher
dividends though, from the perspective of shareholders. At some point
companies (or the companies that acquire them) need to yield a dividend or
else it's all a Ponzi scheme.

~~~
eanzenberg
Yep, and some stocks are priced for a date decades away.

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LeoTinnitus
It's certainly more nuanced than that. However, it does point out the fact
that corporations focus too much on shareholder value as opposed to just
making a good business system...except for the major players that is.

These the so called "too big to fail" types of companies which borderline
monopolize market sectors like Amazon and Walmart. But they don't care during
recessions because they're fine. They essentially are the government as they
have a larger impact on your daily life than the actual government!

It's not so much that the stock buybacks are the straw that broke the camel's
back, it's just another inevitable economic event that the invisible hand
dealt. There is no stopping it. Otherwise we're just back in a labor economy
again where money can't flow where irrational people deem they need to place
it.

~~~
timlangeman
The first point I make is that profit growth has been flat since ~2014 but the
stock market has gone up quite a bit.

My question is: Why had the stock market continued to go up despite flat
profits?

~~~
Enginerrrd
My guess is that the answer to that is cheap debt from the fed keeping
interest rates so low for so long. The stocks had value beyond what you'd
expect from P/E ratiosand assets alone because there was added future value in
the form of anticipated stock buy backs.

~~~
JackFr
If debt is that cheap it would be irresponsible to finance the firm with
equity.

~~~
Enginerrrd
That really depends on your timelines and risk tolerance assessment including
externalities.

To use poker as an analogy: if you aren't sufficiently bankrolled, the correct
play (most positive EV) can involve an unacceptably high risk of ruin. ....and
BTW are you also factoring in the probability of fraud or a government seizure
in your calculations?

------
tathougies
Do people not expect the market to go down when business revenues have been
forced lower due to unforeseen circumstances? The fact is a valuation made in
November 2019 had no way of taking this into account.

This isn't to say whether or not it's a bubble, but I am surprised at the
number of people who think that stock prices going down is due to financial
health of companies rather than people attempting to sell stocks either in a
panick or because they suddenly need the liquid cash on hand (due to job loss)
and are thus willing to sell at a loss.

And regardless of their merits or demerits, share buybacks do increase actual
earnings per share, which is one method to valuate shares. It's like, if there
are four partners in a partnership and two decide to buy out the other's
shares, their shares are now worth twice as much, assuming the corporation
continues making revenue.

Then I hear about corporate debt and how that forces layoffs. The fact is
companies are not going to retain employees when they cannot conduct business,
regardless of cash on hand. It's not even a moral concern. Companies can
simply layoff their employees and have them receive unemployment insurance.
Even if they wanted to be 'ethical' and provide health insurance, the cost of
a severance package with 18 months of health insurance is less than paying
them and providing health insurance. From a corporation's perspective,
irrespective of how much cash or debt they have, layoffs are simply superior.

~~~
zby
"It's like, if there are four partners in a partnership and two decide to buy
out the other's shares, their shares are now worth twice as much, assuming the
corporation continues making revenue." \- I don't understand how you calculate
that. Let's say there is a company with 4 shareholders with equal shares and
with discounted future earnings of $2 million plus $2 million of cash. That
makes the company worth $4 million and each share worth $1 million. The
company then buys two shares for the $2 million in cash it has. That makes the
company worth $2 million (it has no more any cash and the discounted future
earnings are worth $2 million) - and the two shares left are each worth $1
million - exactly like before the buy out.

~~~
tathougies
Companies capital reserves often don't count in valuations. It's just the
discounted future earnings. Cash sitting in a company's coffers would often
count against it, since the rate of return on capital would be lower (larger
denominator), and investors are seeking a higher rate of return.

The fact of the matter is, companies should not keep 'emergency cash reserves'
enough to operate for six months. The money should be returned to
shareholders. Shareholders and other investors should keep liquid cash
reserves for emergencies. Then, when companies face emergencies, they should
issue new stock to the markets, and the saved up emergency capital can be
used. That leaves individual share holders and potential shareholders to
decide the fate of companies, which seems more in the spirit of democracy.

------
kqvamxurcagg
The bubble has been enabled by the Federal Reserve. Quantitative easing and
money printing has served to inflate asset prices over many years.

For some reason markets going up is fine but when they inevitably decline
sharply this is viewed as 'disorderly' and the Fed prints money to keep asset
prices high. The Fed ensures that hedge funds have counter-parties to buy
their toxic overvalued assets.

It's now clear that our economic system is run for the benefit of corporations
and hedge funds.

~~~
abakker
Everyone always seems to knee-jerk forget that corporations are
employers...the economy is run for people. People work for companies.
Companies compete, and the financial gymnastics they do to get there is done
by people also. Companies are not sentient. (you could argue that they have
some meta-sentience, but it is pretty unspecific)

~~~
ej3
Honestly I've always shared a perspective much like this until yesterday
someone mentioned that through the stimulus (I'm not sure of the figures, but
what I roughly recall is) each citizen gets $1200 they're then taxed on, and
companies get the balance as an interest free loan. If the balance of the
stimulus had been simply evenly distributed to individuals, everyone would
have received nearly $10,000.

I can't imagine what would happen if you gave every citizen 10k. I would think
there would likely be something akin to a revolution that may or may not
result in a more robust economy. What the gov't is doing by giving so much
money to existing companies that have already failed vs individuals with the
possibility of failing is very much protecting the existing social structure
of society.

Corporations like these are a hierarchy that generate implicit social
striations in our society. By maintaining this regardless of the fundamental
success of the product or competence of the management, they act only to
preserve the class structure enforced by the institution and thus the
stability of society in a configuration with marginal utility as regards
productivity.

They're clearly ensuring their own future.

~~~
abakker
competition == unemployment. corporate failure == unemployment. innovation ==
unemployment.

Maybe all in the short term, but, this stimulus is specifically looking to
avoid short-term discontinuities.

That said, I'm a big fan of corporate stress tests and capital buffers as
well. I'm not a fan of debt-fueled share buybacks, but, I understand them as a
response to a system that allows them.

~~~
ej3
do you really think it's likely that they can avoid short term discontinuities
in this context? Maybe we should be looking farther ahead?

------
zuzun
This reminds me of a paper I read in the Quantitative Finance section on
arXiv.org, in which the author claimed stock markets are being manipulated by
big portfolio owners, because the gains happen overnight, while the intraday
returns are negative. I'm not endorsing this idea, but I consider it a fun
conspiracy theory and maybe it's a good time to throw this into the discussion
here.

[https://arxiv.org/abs/1912.01708](https://arxiv.org/abs/1912.01708)

~~~
raincom
Even if whatever this paper suggests is true, it won't contribute that much to
the inflation of stocks. In this bull run, index funds have performed better
than hedge funds. As long as the majority of investors (in terms of their
aggregate holds) agree that the price of equities is fair, the ride will
continue.

------
klysm
"When a measure becomes a target, it ceases to be a good measure." (Goodhart's
law)

Does this apply here? It seems you could argue that profit is the one true
number that _is_ a good measure, but it seems even that can be 'hacked' so
that it isn't good anymore.

~~~
TeMPOraL
> _It seems you could argue that profit is the one true number that _is_ a
> good measure_

A measure of what? As a proxy for social utility, it's been thoroughly gamed
and the two have little correlation.

Profit is currently used as a self-serving measure, because you can eat profit
(after exchanging it for bread, or drugs, or yachts). In this sense it can't
be hacked. Accounting around it can be and is, though.

------
LatteLazy
One man's bubble is another man's under valuation.

Big moves when there is big news (like a global pandemic say) are normal
events.

The thing I find concerning is why the FED are "intervening". Dumping cash
made sense during a cash shortage. But when there are actual, real, concerns
about the future (coronavirus), price falls are perfectly correct. They don't
need "fixing". Happy to be corrected if anyone knows?

~~~
solotronics
It's happening at some layers above where personal finances occur. There is a
massive demand for digital USD (bank liquidity) around the world, this is
coming from a few directions such as domestic and international companies
taking out new loans and calling in terms of existing loans to keep afloat
without having income right now. International banks needing more USD to meet
increased demand. It's like a perfect storm of massive hidden types of debt
and leverage all came crashing down at once, there are 10x the amount of the
stock market in derivatives such as futures and options so when these bets
went bad it is causing the ultimate dollar black hole to occur worldwide at
the same time.

~~~
LatteLazy
Thanks, the international side and "flight to safety" hadn't occurred ti me
(and I am an international!). That makes more sense.

------
mixmastamyk
Is the sky blue? The Pope catholic?

Vast money supply inflation, rock-bottom interest rates, stagnant wages, share
buybacks. All accelerating over the last several decades.

------
skoczko
Here's what I don't get: this article claims that big (since that's what
matters for stock market index levels) business sits on a mountain of debt. At
the same time many economists (e.g Yanis Varoufakis) claim that big business
sit on mountains of cash kept in tax heavens rather that "working" for the
benefit of the economy. Which way is it and are there any confirmed statistics
to check it?

~~~
zyang
Both. Racking up domestic debt using offshore cash as collateral. It's like
getting a low interest loan using your 401k.

~~~
skoczko
Ok, thanks. Then the premise of this article is even weaker. Companies do
generate huge profits albeit most of the hidden through accounting
engineering. It's more likely that the inflated stock prices represent the
actual "value".

~~~
lotsofpulp
And a lack of better places to put the money.

------
jlj
How about taxing corporate stock buyback transactions at a high enough rate to
make it hurt, and keeping the money set aside for social safety net and
training programs that support the people who are losing their jobs.

History has shown again and again that corporate tax cuts and repatriation
schemes go right into stock buybacks and don't trickle down nearly enough to
individuals. So tired of corporate welfare.

------
taurath
Assets across the board are and were massively inflated because there's tons
and tons of money out there any not enough investments for it.

------
andygcook
There was an interesting interview with Chamath Palihapitiya on CNBC last
week. Whether you like him or not, he made some good points around buy-backs
and earnings per share manipulation.

Worth listening to the full interview if you have 15 minutes:
[https://www.youtube.com/watch?v=NvEWez59fbI](https://www.youtube.com/watch?v=NvEWez59fbI)

~~~
snarf21
Exactly, the Fed has artificially held rates low so companies are borrowing
money for practically 0 to keep the price up and keep CEO compensation high.
The only way to really fix the buyback problem is to outlaw stock based
compensation for the C-suite and BOD. Then they might start focusing on long
term corporate health instead of stock price and short-term quarterly numbers.

------
JackFr
Issuing debt to buyback stock isn’t ‘financial engineering’ its trying to
address the fundamental problem of corporate finance. You have two sources of
capital, debt and equity. What is the optimal capital structure of the firm.

There is no moral component as to whether a firm should be financed with debt
or equity. While EPS has a smaller denominator, it also has a smaller
numerator as earning will reflect the interest payments on the debt.

------
CapriciousCptl
For a more balanced view, you can turn to JP Morgan's Guide to the Markets.
It's a reliable summary of actual data so you can draw your own conclusions.

[https://am.jpmorgan.com/blob-gim/1383407651970/83456/MI-
GTM_...](https://am.jpmorgan.com/blob-gim/1383407651970/83456/MI-GTM_1Q20.pdf)

~~~
timlangeman
One of my main points is that you need to look _beyond earnings per share_ to
see the bigger trend.

What slide/s would you use from the JP Morgan Guide that is better than the
St. Louis Fed chart I featured?

    
    
      * https://fred.stlouisfed.org/graph/?g=qx3r
    

The Chart on Page 7 looks fantastic but it is earnings per share, not total
profits before taxes.

The question I would ask is why the stock market graph looks so different than
the St. Louis "Corporate profits before tax" graph?

My hypothesis is that many of these companies borrowed a lot of money in the
bond market to buy back their shares and thereby juice their earnings per
share.

~~~
CapriciousCptl
I don't understand the point you're making. Stagnant corporate profits can
happen for a lot of good reasons, particularly when there's GDP growth over
the same period. Increased labor pay, increased competition, cheaper and
higher quality products for consumers, long-term minded growth at the expense
of short-term profit taking, etc.

Profit also involves some major accounting nuances. In SAAS, for instance,
advertising costs resulting in customer acquisitions are generally accounted
for upfront, reducing accounting profits in the period of acquisition. This is
opposed to other industries, where investments are more easily capitalized and
then charged over their useful life.

------
amiune
The amazing thing about bubbles is that you can only know that was a bubble
only after it explodes but you can never predict it before.

~~~
TheOtherHobbes
Before 2008 it was amazing how many people outside of economics, finance, and
politics were able to see a disaster coming, but almost everyone in those
sectors was completely blindsided.

~~~
sokoloff
How many of those people held that same view for 5 years before finally being
right?

It’s easy to call a market reversal if you’re comfortable calling 9 of the
next 2 reversals.

------
kakoni
In Europe we have this thing called “covered bonds”. In scandinavia Atleast
half of the housing loans are packaged into these.

------
vimota
OSAM has a great data-driven analysis of this question and end up on the other
side in the conclusion:
[https://www.osam.com/pdfs/whitepapers/_2_Commentary_Buybacks...](https://www.osam.com/pdfs/whitepapers/_2_Commentary_BuybacksBearsBulls_Oct-2016.pdf)

~~~
entee
So many problems with this analysis. 1.) main paper cited is from 2006, 2.)
article is from 2016 3.) much of the data is older, several plots go to 2014
4.) almost no analysis that looks at long term profile of companies that do
this over and over

------
resters
One use of financial engineering is to distill risk into very narrow products
that allow innovative instruments to be created.

The problem is that systemic risk is then distilled out of the priced
instruments that are created, yet those instruments are significantly more
vulnerable to systemic risk than simple equities, etc.

------
pathseeker
Blog spam that is effectively just a gish gallop of weak points that are each
contentious on their own and it uses citations of Seeking Alpha which is about
as good as a citation of Medium.com.

------
pjdemers
Companies borrow money to buy back their shares because they can borrow for
long terms at interest rates below the long term of inflation.

------
JMTQp8lwXL
They've buried the lede. In the last sentence, in the last 6 words.

> With Corporate profit growth unmasked and the Baby Boomer’s transition into
> retirement, it seems unlikely that stocks will make a quick return to their
> prior levels unless governments engage in massive asset inflation.

It is not the Federal Reserve's mandate to inflate asset values, however it
tends to be a consequence of their mission to support low unemployment and
some stable, positive inflation. We have $6 trillion in emergency stimulus
arriving shortly -- two thirds of that support is monetary policy.

------
LatteLazy
The first thing you learn in accounting school is which numbers are real
(revenue) and which are made up (profit).

------
kaesar14
I find this scary and telling.

"It is too early to say where the bottom is to this recession, but we have
reason to believe the Millennials and Generation X do not have the resources
to purchase the stock that Baby Boomers want to sell at prior market highs.
With Corporate profit growth unmasked and the Baby Boomer’s transition into
retirement, it seems unlikely that stocks will make a quick return to their
prior levels unless governments engage in massive asset inflation."

It's almost like bankrupting a generation by forcing them through punishingly
expensive higher education, obscene healthcare costs, absurd cost of living in
major metropolitan areas, and stripping worker benefits makes an entire
generation of this country's youth unable to prosper like their predecessors.
I truly have no idea what will be left behind for me and my peers, when all of
this is said and done.

~~~
vzidex
> I truly have no idea what will be left behind for me and my peers, when all
> of this is said and done.

I'm in the same boat, as a new grad about to enter the labour market with a
computer engineering degree.

While the situation may seem impossible, once this is all said and done we
will still have each other - with everyone the wiser having witnessed the
collapse of our current ridiculous system. We're two weeks into isolation and
layoffs where I live, and I'm already seeing lots of graffiti and posters
about rent strikes.

One day the boomers will die, penniless because their wealth only exists in an
overly-engineered financial system, and the young will be left to rebuild a
more intelligent and caring society.

~~~
jki275
Ah the misguided enthusiasm of youth.

You'll grow up, don't worry.

It will amaze you how much smarter your "boomer" parents get as you get older.

~~~
dang
This crosses into personal attack. Please don't do that, regardless of what
someone else posted.

I'm sure you meant it in an avuncular way, but that doesn't translate so well
on the internet.

[https://news.ycombinator.com/newsguidelines.html](https://news.ycombinator.com/newsguidelines.html)

~~~
jki275
No, that's not a personal attack. "Ok Boomer" is personal attack in a lot of
places, but I guess not here...

It's banter, it's common on the internet, it's been common on the internet for
decades.

~~~
dang
I've chided the other commenter for dropping the "Ok boomer" trope here. It's
definitely not ok.

------
gowld
This wins today's award for least necessary question mark.

~~~
alexandercrohde
I refuse to upvote on principle a one-liner quip on this site. But you're
right, the insincere pretense of a question gives the air of a phony attempt
at objectivity.

Of course, that's entirely independent of whether the points are valid or not.

------
CrankyBear
Conspiracy Theories R Us.

