Wednesday, February 19, 2014

On Wall Street More is Never Enough

Despite profit margins (as % of GDP) being the highest in U.S. history, if profits don't continue to grow, then the stock market will fall. That's how we got to this fatal juncture, obscene profits were never enough, because the stock market only goes up when profits grow...

Securitization Powers Limitless Greed 
Forgive the lesson, however, 99% of people investing in stocks don't really understand how the stock market works. As stated above, if profits stay the same, regardless how high they are, the price of a given stock (or market) will not change. Leaving aside "multiple expansion" which I will discuss below, only when earnings grow, will stock prices go up. Stocks are comparatively valued not by their nominal prices, but by their earnings multiples (Price divided by Earnings) P/E. If "E" doesn't change, then P doesn't change, assuming the same multiple abides - and generally multiples are fairly stable across stocks and industries. 

All of this is a long way of saying that Wall Street is in a constant state of dissatisfaction with the status quo regardless of how lucrative it is. If a family owned business was turning a massive profit, the family would likely be very happy. However, if that company went public and turned a massive profit but wasn't growing, then the stock price would be stagnant and shareholders would be very unhappy. 

Microsoft: The Most Profitable Company In Human History
Dollar for dollar of revenue, Microsoft is the most profitable company in history. That's the benefit of being an operating system monopoly. Its incremental cost of selling another unit of software is de minimis. It has gross profit margins of 68% and net profit margins of 31%. Before it got into xBox and other bullshit, its profit margins were even higher. 

This company churns out $28 billion in operating cash flow every year. 

And yet, for all that, the stock has gone nowhere for 15 years straight:

Microsoft, dividend reinvested - almost back to where it was in Y2K:


This is Microsoft Without Dividend Reinvestment i.e. the true stock price:
Those big drops back in the 1990s are stock splits, however, there haven't been any stock splits for 10 years because the price of the stock hasn't changed in 10 years, despite churning out ~$200+ billion in free cash flow in a decade:

The Most Profitable Company In Human History Pays Less Than a Treasury Bond
Microsoft makes a shit ton of money, but its earnings are not growing fast enough to make Wall Street happy. It's "dead money" aside from a meager 3% dividend. The only people making money off of this stock are insiders who issue cheap stock to themselves and use corporate profits to buy it back. Steve Ballmer walked away with $15 billion despite the stock losing 50% of its value during his entire term as CEO. On the day he resigned he made $750 million just due to announcing his own resignation. You can't make this shit up.

One company's costs are another company's revenues
I think we all see where this is going. Wall Street's relentless drive for more was inevitably going to lead to cannibalization of the underlying economy. Jobs and industries were traded for quarterly profit increases which drove stock prices. These dumbfuck Dow Worshippers don't realize that their jobs will eventually be traded for a few points higher on the Dow. It's only a matter of time.

Multiples are Expanding
However, per the theme of this blog, this entire game is coming to a close. Getting back to the topic broached above - multiple expansion - the only other way the Dow can move higher is if investors are foolish enough to keep paying more for the same amount of earnings i.e. price goes up while earnings stay the same. This is known as multiple expansion and generally occurs late stage in a rally when investors are most fat and happy:

Here is the past 20 years of multiple expansion. 
The green line is the earnings yield which is the inverse of P/E, it's E/P. So when this line is going up, the multiple is falling, whereas when it's going down the multiple is expanding. Notice that in the 1990s valuations were cheapest in the mid-1990s and then became ever-more expensive. In 2003-2007 however, earnings kept pace in lockstep with the stock market. Today, not so much - Multiple expansion started in 2012 when the Fed initiated QE "infinity":

The Historically Inflated Earnings Yield Circled in 2012 was Driven By Mass Outsourcing:


On Wall Street: More Is Never Enough