Market can't rely on increased corporate earnings

By DAVID MOON, Moon Capital Management, LLC
July 5, 2009

During the three months ended June 30, the Dow Jones Industrial Average increased 11 percent. One thing is obvious: either the financial crisis is over, or it’s not.

I’m glad that’s cleared up.

An 11 percent increase is a significant jump, especially when it happens over a period as short as three months. But when the market jumps this much, this quickly, it’s easy to lose sight of the context of the movement.

Even after the second quarter performance, the Dow Jones Industrial Average sits about where it did in mid-January of this year. The index is still 40 percent below its level on October 9, 2007. This recovery of the past 12 weeks is substantial only if looked at through a prism that somehow blocks outs the previous 18 months.

Unless you’ve figured out the secret to day-trading or can pick market tops and bottoms, investing is a long-term proposition. Over the long-term – at least as defined as the last 25 or 30 years – we’ve been conditioned to consider every market decline as a broad-based buying opportunity.

One problem with using the most recent quarter-century as our guide, however, is that 2009 is not 1982. When we are talking about changes in stock prices, the starting point matters.

Many factors combined to drive the Dow Jones Industrial Average from 1,000 in 1982 to its current level. One obvious influence has been an expansion in P/E ratios. In the early 1980s, P/E ratios were much lower than they are now. Simply doubling the market’s P/E multiple, without any change in the underlying earnings, would cause the DJIA to increase from 1,000 to 2,000.

The stock market has also enjoyed significantly higher corporate earnings over this time frame.

What you may not realize, however, is that much of those earnings gains have resulted from increases in efficiencies by large companies. Companies like Johnson and Johnson squeeze more earnings out of their revenue dollars than they used to.

In 1982, the U.S. stock market ended the long secular bear market that began in the 1960s. At that time, the pre-tax profit margin for Johnson and Johnson was 14.5 percent. By 2008, it had increased more than 80 percent, to 26.6 percent. Home Depot’s pre-tax margin increased 32 percent over that same period. Pepsi’s and Coke’s doubled. Proctor and Gamble’s margin jumped 90 percent.

Either by acquisitions or simple increased operating efficiencies, these businesses became more valuable by significantly reducing their relative operating expenses.

Those types of massive, broad-based efficiency gains are likely over. In 10 or 20 years, Coca Cola’s pre-tax margin won’t double again.

Whether you realize it or not, when you make an investment, you are either making or agreeing to a host of economic and financial assumptions. Be careful if one of those is that businesses can continue a 27-year history of efficiency improvements.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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