Monday, September 24, 2012

The Paradox of Profit Margins and Another Look at the Theory of Everything

From our November 2011 post "Jeremy Grantham on Corporate Profits and Mean Reversion":
Back in April we awarded Mr. Grantham the presigious CLoD in "Climateer Line of the Day: Jeremy Grantham on Profit Margins Edition":

“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” 
– Jeremy Grantham
That post had a half-dozen links to commentary on profit margins.
Here's Mr. Grantham's latest via Bloomberg...
In every business I've ever studied, the margins of early players were high, brought in competition and decreased.
Every single one. So what is going on this time around?
Margins aren't acting as expected and smarter people than I have noticed. That Bloomberg link above went to a story entitled "Grantham Calls Corporate Profits Freakish".

Here's Izabella Kaminska at FT Alphaville with more:
A time of hoarding and inflation fears, 1930s edition
...It’s easy to confuse the above for contemporary comment, but… the two clippings actually originate from the New York Times archive, circa 1933.

Before we explore the degree to which history is repeating itself, we’d like to explain our position on the story to date. (And for ‘we’ it’s fair to read Izzy.)

You see, contrary to popular belief, our working theory is that the crisis results as much from the conjoined effects of a suddenly over-abundant and over-productive world (on account of technology advances) — something which has been exacerbated by a shortage of safe assets, credit and money relative to goods available — as it does from credit profligacy in the mid-naughties .

In that sense, we believe that the credit binge, rather than being the ultimate cause of the crisis, was possibly only one of its symptoms.

We postulate that in an over-productive economy it’s natural for return on capital to be extinguished, since the presence of a persistent output gap forces prices of goods and services towards the cost of production. Indeed, if prices fall below the cost of production for a significant period of time, output of both products and resources must be cutback on a permanent basis — usually against corporate interests and at the cost of real jobs.

At this point the economy has to reset to focus on efficiency rather than the hope of capital returns....MUCH MORE
If you're interested in the effect of hoarding on commodities prices Janet Netz, PhD did a paper I liked, "The Effect of Futures Markets and Corners on Storage and Spot Price Variability". I'll see if we have an ungated copy.

Remember, the spectrum runs from storage to hoarding to market corners.
And corners in commodities refers to physical, you can't corner a commod by simply buying futures or forwards, you also have to take up the physical supply.
Conversely, squeezes are accomplished in the futures..

A couple decent papers on this aspect of the abundance theory are:
"Large Investors, Price Manipulation, and Limits to Arbitrage: An Anatomy of Market Corners" and
"Market Manipulation, Bubbles, Corners and Short Squeezes"
The only way to combat abundance is with artificial scarcity, i.e. manipulation.

The Theory of Everything
Okay, maybe not everything but quite a bit of what is important.

You've got your comparative advantage, your manufacturing technology, mercantilism as policy, why the U.S. and Japan parted ways in 1990, inflation pressures, negative real interest rates and domestic asset bubbles along with hope and fear for Africa and what's up with China....