US Stock Markets and the Austrian Business Cycle

Following the bullish outlook from Warren Buffett’s aggressive actions on the US stock markets, I came across Bloomberg’s chart of the day which suggests that S&P 500 earnings have lagged price actions of stocks, which implies of the potential for more upside movements.

From the Bloomberg,

The Standard & Poor’s 500 Index’s failure to keep pace with record corporate earnings may signal the benchmark equity gauge will surge if it returns to its historical relationship with profits.

The CHART OF THE DAY shows that four years ago, when the S&P 500 lagged behind trailing 12-month corporate profits, the measure went on to reach an all-time high of 1,565.15. The chart also shows that while combined earnings by companies in the index have exceeded the previous peak reached in 2007, the measure itself is 19 percent below that October 2007 record.

Companies have “increased efficiency, productivity and profit margins,” said David Goerz, the chief investment officer at Highmark Capital Management Inc., in a telephone interview yesterday. “That’s resulted in strong performances at a time when investors are very skeptical about the future. It’s not surprising that the market would be trading at a significant discount.” He said, “There’s a lot of upside for the U.S. equity market.”

In the meantime analyst Ed Yardeni says that while the third quarter has been a good earnings season, many analysts seem to be cutting earnings forecasts.

The reason says Mr. Yardeni,

They must be getting downward guidance from company managements. Yesterday’s FOMC statement notes that “there are significant downside risks to the economic outlook, including strains in global financial markets.” The Fed isn’t alone in lowering expectations for economic growth next year. October’s surveys of purchasing managers showed recessionary readings for the major economies of Europe. Company managements must be seeing a worrisome deterioration in the prospects for European economies and telling analysts to curb their enthusiasm about Q4 and 2012.

In my view, capital spending, credit growth and private domestic investments have been all pointing to a recovery…

And I think the above dynamics seem to be reflecting on the anticipated consequences of the boom bust policies or a partial confirmation of the Austrian business cycle theory (ABCT).

Friedrich von Hayek wrote of the influence of monetary inflation to business profits (and to stocks). (bold emphasis mine)

Now the chief effect of inflation which makes it at first generally welcome to business is precisely that prices of products turn out to be higher in general than foreseen. It is this which produces the general state of euphoria, a false sense of wellbeing, in which everybody seems to prosper. Those who without inflation would have made high profits make still higher ones. Those who would have made normal profits make unusually high ones. And not only businesses which were near failure but even some which ought to fail are kept above water by the unexpected boom. There is a general excess of demand over supply--all is saleable and everybody can continue what he had been doing…

But, and this brings me to my next point, "full employment" in his sense requires not only continued inflation but inflation at a growing rate. Because, as we have seen, it will have its immediate beneficial effect only so long as it, or at least its magnitude, is not foreseen. But once it has continued for some time, its further continuance comes to be expected. If prices have for some time been rising at five percent per annum, it comes to be expected that they will do the same in the future. Present prices of factors are driven up by the expectation of the higher prices for the product--sometimes, where some of the cost elements are fixed, the flexible costs may be driven up even more than the expected rise of the price of the product--up to the point where there will be only a normal profit.

But if prices then do not rise more than expected, no extra profits will be made. Although prices continue to rise at the former rate, this will no longer have the miraculous effect on sales and employment it had before. The artificial gains will disappear, there will again be losses, and some firms will find that prices will not even cover costs. To maintain the effect inflation had earlier when its full extent was not anticipated, it will have to be stronger than before.

So like users of illegal substance, more and more inflationism will be needed to sustain the current sanguine conditions of profits.

Nevertheless with almost every major central banks in a renewed easing mode (QEs and lowering of interest rates), my guess is that we could be at the next phase of the business cycle. And importantly, consumer price inflation will pose more of a risk than of an economic slowdown as projected by the mainstream. Again the boom bust process at work.