Wednesday, 5 June 2013

A Summary of James Surowiecki's "Boom or Bubble"

Warren Buffett has noted that two highly important data points have a gravity-like effect on the stock market: the price/yield of bonds, and the ratio of corporate profits to GDP.  He remains bullish on stocks, explaining that they are attractive compared to bonds.  In the past, Buffett would likely be cautious about the second number, though, given that corporate profits now stand at over 10% of GDP, far higher than the 6% it has averaged in the past.  Yet he remains upbeat on the value of stocks, and James Surowiecki explains why.

In "Boom or Bubble," Surowiecki explains that three secular shifts have boosted corporate profits, and why those inflated earnings are here to stay.  First, the average corporation paid a tax rate of nearly 50% in 1951, over 30% in 1965, but now pay only 20% or so.  As corporate tax rates have fallen almost everywhere in the past few decades, any movement from here will almost certainly continue in a downward direction.

Second, the denominator - US GDP - is no longer as relevant as it was in the past.  Due to globalization, a third of corporate profits now come from abroad, compared no almost nothing a few decades ago.  Moreover, the mature US economy will grow at a significantly slower pace than the economies of the developing world, so the non-US portion of profits is sure to grow over time.

Third, the decline of unions combined with a sluggish job market has led to a much diminished labor force.  For years wages have risen slowly, if at all, and every dollar not spent on salaries and benefits boosts a firm’s bottom line.  Even as the labor market strengthens, Surowiecki suggests, increased sales will likely counteract any pressure from squeezed margins.

Anticipating the predictable response - that people always claim that "This time is different" as bubbles inflate - Surowiecki argues convincingly that this time is indeed different.  Wary investors should step off the sideline and into the game, because US stock markets are likely to keep setting records for years to come.

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