That’s A Lot of Manure

Economic history is full of roadblocks, things that appear impossible to overcome, until some technological advance comes along and changes the dynamics completely. Railroads changed U.S. transportation in the late 1800’s, fertilizers changed our ability to feed a growing global population. Even the automobile, now the bane of environmentalists, was once considered a miracle environmental cure. In 1900, the 100,000+ horse population in New York was producing over 2.5 million pounds of manure every day!

We suspect the future will look much the same as the past in the sense that technological advances will allow us to overcome the seemingly insurmountable. Global warming is highly unlikely to be solved with regulation, or more windmills and solar panels. If it is to be solved, it will likely be due to some major technological advancement we have yet to see (which suggests that we might be better off funding such research than de-funding fossil fuel companies).

Technology advancements have consistently saved the day, but in economic terms these technological advances have simply improved productivity; our ability to do more with less. In the long run, economic growth relies on productivity growth. The invention of the personal computer allowed computer power to be used at a local level and was a major shift in productivity. The ATM allowed banks to use fewer tellers, improving employee productivity, but it also allowed customers to be more productive. At my first real job, I was paid every two weeks with a paper check, which I promptly brought to a bank, where I waited on line with countless others to deposit or cash that check. The ATM meant less time wasted out of the office and more time being productive at my job. The idea is that productivity benefits ripple through an economy. When businesses are more productive, it allows them to pay employees more money, and offer costumers lower prices, in addition to making more profit. The benefits are shared.

Accurately measuring productivity growth has long been a problem for economists, and it is one that still has not been solved. Despite that inability to accurately measure it, the benefit of productivity gains over the years are obvious; our quality of life has been improving.

The reason for our comments this morning arise from a research paper published by Michael Smolyansky, an economist working at the Federal Reserve, in June of this year, titled ‘End of an era: The coming long-run slowdown in corporate profit growth and stock returns’. Unlike most research from the Fed’s army of PhD. Economists, this research was elegantly simple. The findings are an eye opener, but you don’t have to be an economist or mathematician to understand it.

In this report, the author makes the case that over the past three decades, the decline in interest rates and corporate tax rates accounts for the majority of the period’s exceptional stock market performance. In addition, because rates have been so very low and corporate tax increases are more likely than not, this period of exceptional stock market performance is over. The question we pose, which the author leaves unaddressed, is whether some technological change, such as Artificial Intelligence, can change the productivity dynamics of the economy, allowing margins to hold or even rise over coming decades due to the cost savings related to the implementation of AI across industries.

The authors case is summarized in the following table from the report. Allow us to explain:

  • In Panel A: Real (inflation adjusted) Operating Income (EBIT, or Earnings before Interest and Taxes) grew at a 2.4% rate from 1962 to 1989, and a 2.2% rate from 1989 to 2019. In each period, this was less than GDP growth of 3.6% and 2.5%, respectively (line 6).

  • Also in Panel A, Real Net Income grew at a slightly lower rate than EBIT (2%) from 1962 through 1989, but net income grew at a much higher rate than EBIT (3.8%) from 1989 through 2019.
  • Accounting tells us that

EBIT, less interest expense, less taxes = Net Income

  • If EBIT grew at only 2%, the only way Net Income could grow at 3.8% is if interest expense and/or taxes were much lower, and, in fact, they were. Although corporate leverage (use of debt) rose, interest rates came crashing down and interest expense along with it. In addition, effective corporate tax rates also came crashing down.

His conclusions are on Panel B. Here is what it says:

  • From 1962 through 1989, 2.4% EBIT growth accounted for 120% of Net Income growth. The impact of rising interest rates and tax rates reduced the growth in net income to 2%.
  • From 1989 through 2019, EBIT growth accounted for only 58% of the growth in net income. The other 42% was due to lower interest rates and lower tax rates, which is clearly unsustainable.
  • The author logically concludes that there is precious little room for interest rates to move any lower than they were 2021.
  • He also logically concludes that in light of the massive deficits being run by the U.S., corporate tax rates are also unlikely to go lower.
  • With real GDP growth running at very low rates, it is logical that growth in EBIT will also be slow and, if the past 60 years are any guide, will also be slower than real GPD growth.

In the author’s own words, this is the impact on stock market returns:

“This has serious implications for stock returns. Stock price growth can only come from either earnings growth or from an expansion in P/E multiples. If real earnings growth is not likely to exceed 2 percent per year over the long run, then the outlook for stocks is bleak. Stock price performance above this 2 percent real rate could only be accomplished by the perpetual expansion of P/E multiples. Clearly, this is unsustainable.

Moreover,… P/E multiples are primarily a function of earnings growth expectations and discount rates. The relevant discount rate equals the risk-free rate plus a risk premium component. From 1989 to 2019, the decline in risk-free rates accounts for all of the expansion in P/E multiples. Looking ahead, any further expansion in P/E multiples will be severely constrained by the extent to which risk-free rates can fall below 2019 levels.”

This sounds dire for stock market investors, and the may be correct. But he may be incorrect too. Low productivity growth is this generations version of 2.5 million pounds of manure in the street. If AI, and other technology advances, allow us to break that trend and rejuvenate productivity growth, then the author’s conclusions need not be correct.


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By: thinkhouse