Sunday, June 29, 2014

It was the best of times, it was the worst of times



You may know by now that the final revision of U.S. first quarter GDP revealed a shocking 2.9% decline while its mirror image, gross domestic income (GDI), was off by 2.6%.

As Scott Sumner has pointed out twice now, the huge decline in GDI is almost entirely due to a fall in corporate profits. Whereas employee compensation, the largest contributor to GDI, rose from $8.97 to $9.04 trillion between the fourth quarter of 2013 and the first quarter of 2014, corporate profits fell from $2.17 to $1.96 trillion (see blue line in the above chart) This incredible $198 billion loss represents a 36% annualized rate of decline!

A number of commentators have pointed out the difficulty in squaring this data bloodbath with reality. After all, Wall Street has not been announcing 36% quarter on quarter profit declines. Rather, earnings per share growth has been pretty decent so far this year. If earnings were off by so much, then why are equity markets at record highs? Why have there been no layoffs? It's hard to believe that a bomb has gone off when there's no smoke and debris. Investors are patting themselves down to make sure they had no wounds or broken body parts and, coming up clean, are shrugging and buying more stocks.

I'm going to argue that the odd disjunction between the numbers and reality may have arisen due to something called money illusion. We live in a historical-cost accounting world in which stale prices are used as the basis for much of our profit and loss calculations. But the gunshot rang out in a different universe, one in which accountants rapidly mark costs to market. At some point we in the historical-cost world will feel the repercussions of the gunshot since everything is eventually marked to market. For now, however, no one seems to have noticed because we're all caught up in an the illusion created by accountants focused on the ghost of prices past.

More specifically, the folks at the Bureau of Economic Analysis who compile GDI report a different corporate profit number than the profit numbers being bandied around on Wall Street during earnings season. Wall Street profits are by and large paid out after depreciation expenses, and these have been accounted for on a historical-cost basis. This is the red line in the above chart. The BEA's number, represented by the blue line in the chart above, represents the profits that remain after depreciation expenses have been marked to market. The choice between mark-to-market depreciation accounting and historical-cost accounting can result in large differences in bottom-line profit, as the last data point in the chart illustrates.

For instance, consider a manufacturing company that earns revenues of $100 per year from a machine that it bought for $600. It depreciates the machine by $60 each year over 10 years, earning a steady $40 in profits ($100 - $60). Now imagine that all over the world machines of this type are suddenly sabotaged so that, due to their rarity, the cost of repurchasing a replica doubles to $1200. If the manufacturing company uses historical cost deprecation, it will continue to bring in revenues of $100 a year, deducting the same $60 in depreciation to show $40 in earnings. All is fine in the world. But if the firm uses mark-to-market depreciation, the cost of using up the machine will now reflect the true cost of replacing it: $120 a year ($1200/10 years). Subtracting $120 from the annual $100 in revenues means the company is losing $20 a year, hardly a sign of health.

It's easy to work out an example that shows the opposite, how a glut in machinery supply (which would drive the replacement cost of the machine down) is quickly reflected in a dramatic improvement in earnings after mark-to-market depreciation expenses, but earnings after historical-cost depreciation show nothing out of the ordinary.

Thus we can have one profit number that tells us that all is fine and dandy, and another that indicates the patient is on death's door. An individual's perception of the situation depends on which universe they live in, the historical cost universe or the mark-to-market one. The GDI explosion has gone off in the latter (the BEA uses a mark-to-market methodology), but since we experience only the former (the Wall Street earnings parade is entirely a celebration of historical-cost earnings per share data) we haven't really felt it... yet.

Yet? Even a company that lives in a historical cost accounting universe will eventually have to face the market price music. Imagine our sabotage example again. If our company uses mark-to-market accounting, it will immediately know it is facing a problem since its $100 revenue stream is failing to offset the $120 cost of machinery depreciation. However, if it uses historical cost accounting then our company continues to enjoy what it perceives to be a revenue stream that more than offsets its historically-fixed $40 cost of machinery. However, once that machine inevitably breaks down and needs to be replaced with a $1200 machine, a new historical cost base will be established and depreciation will suddenly rise to $120. Several quarters too late the company will realize that it is now operating in the red. Had it marked deprecation to market, that realization would have come much sooner.

If I had to speculate, here's a more detailed story about the last quarter. US corporate revenues were particularly underwhelming between Q4 2013 and Q1 2014 due to the cold weather. At the same time, we know that a number of government stimulus acts that had introduced higher than normal historical cost depreciation allowances (this allows firms to protect their income from taxes) were rolling off. Flattish revenues were therefore offset by smaller deprecation costs, resulting in a decent bump to headline earnings numbers, as the red line in the chart shows. Everything looked great to majority of us who inhabit the historical cost accounting universe.

However, mark-to-market depreciation accounting used by the BEA strips out the effect of the expiring depreciation allowances, thereby removing the bump. The combination of flattish revenues and higher market-based depreciation expenses (perhaps due to some inflation in the cost of capital goods) would have conspired to create a fall in the blue earnings series, and therefore a groaningly bad quarter in our mark-to-market universe.

In any case, the crux of the issue is that Wall Street's headline numbers indicate that corporate America did a better job in the first quarter of 2014 generating the cash necessary to replace worn out capital than it did in Q4 of 2013. The BEA numbers are telling us the opposite, that corporate America did a poorer job of covering the costs of wear & tear. Neither of the two numbers is wrong per se, but as I've already point out in my example, mark-to-market methodology is the first to reveal problems while historical cost accounting will follow after a lag.

As I've already hinted, the fact that Wall Street hasn't yet noticed that it just lived through a miserable quarter can be attributed to money illusion: a phenomenon whereby people focus on nominal rather than real values. In this specific instance, investors are so obsessed with headline changes in earnings that they fail to adjust that number for the true cost of using up machinery. Irving Fisher himself described a version of this mistake in his book The Money Illusion:
...during inflation the cost of raw materials and other costs seem to be lower than they really are. When the costs were incurred the dollar was worth more than it is later when the product is sold, so that the dollars in the original cost and the dollars in the later sale are not the same dollars. The manufacturer is deceived just as was the German shopkeeper or the Austrian paper manufacturers who thought they were making profits.
How likely is it that Wall Street, full of so many bright individuals, is being fooled by money illusion? It's not inconceivable. Even Scott Sumner volunteers that he doesn't believe the BEA's numbers due to soaring stock prices and strong earnings, thus falling prey to that very same affliction that serves as his blog's namesake. Money illusion can happen to the best of us.

10 comments:

  1. Hi JP!

    I have a real trouble to follow your thoughts mostly because GDP (and GDI which is the same) doesn't include depreciation at all, or that is, at least, what Wikipedia says. Consequently the profits included in the GDP are the profits before depreciation expenses are accounted for (the gross profits).

    If you add (or rather substract) the depreciation costs to the GDP, you get a different measure, called appropriately NET domestic product (NDP), which is not the one in question.

    So, it should be irrelevant for the GDP (and GDI) calculation, whether you calculate the depreciation at the historical or the mark-to-market basis. And if so, what is your post about?

    Or did I get it entirely wrong and you are speaking about some other kind of depreciation?

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    1. "Depreciation (or capital consumption allowance) is added to get from net domestic product to gross domestic product." http://en.wikipedia.org/wiki/Gross_domestic_product

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  2. Noise illusion can happen to the best of us too!

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  3. JP, O/T: quick question: if you had a theoretical model of the price level (P) that worked for different economies, so you could make plots like this and this, i.e. demonstrating how your model compared with the empirical data, and you wanted to compare with other macro modelers doing the same thing, where would you turn first? Any particular name to look up?

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    1. Sorry Tom, I don't know much about modeling.

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  4. Nice post. Doesn't the lag associated with historical cost accounting, and its potential to trip up Wall Street and economic forecasts, suggest that some other method would be preferable?

    And while I'm still undecided on Austrian business cycle theory, the real possibility that Wall Street might still be fooled occasionally by something as simple as historical costs seems to lend credibility to the idea that central bank induced "noise" w.r.t. interest rates and relative prices really could distort investment and consumer borrowing decisions. A common critique of ABCT is that it assumes that normally astute entrepreneurs are just dopes when it comes to interpreting interest rate movements and the forecasting the path of future central bank policy. But really, how many investors and business owners could accurately give a description of how monetary policy works today, let alone predict how the central bank will act in the future?

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    1. "Doesn't the lag associated with historical cost accounting, and its potential to trip up Wall Street and economic forecasts, suggest that some other method would be preferable?"

      LIFO accounting for inventories and market-based accounting of depreciation would probably be good additions to a firm's financial reporting requirements. But they already report so much data these days.

      "...the real possibility that Wall Street might still be fooled occasionally by something as simple as historical costs seems to lend credibility to the idea that central bank induced "noise" w.r.t. interest rates and relative prices really could distort investment and consumer borrowing decisions."

      I think its reasonable that people can be fooled for a while. After a period of rising prices investors will start to learn about the discretionary effects of historical cost accounting and start to make the necessary analytical adjustments on their own.

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  5. Regarding your up front example – in general, I’m not sure this is right.

    Think of historic depreciation accounting as a hedge for the required repayment of historic nominal debt incurred. If the machine is financed by debt, then deprecation allows the accumulation of cash equivalent to the required debt principal repayment. That is a return of nominal capital.

    Everything else that pertains to this historic transaction is captured in the income statement – including the expense of paying interest on the debt and the required/realized return on equity.

    Apart from that, any relative increase in the cost of new machinery is covered by the expected economics when that transaction occurs. The new pro formas have to allow for a required return on equity on that basis (and all the rest, including required depreciation). But that doesn’t happen until an actual transaction to buy a new machine.

    In other words, the historic depreciation is not intended and not required to cover increases in replacement cost.

    Markets are expected to look through this, including understanding the difference between profits generated from past decisions and expected future profits generated in large part by future decisions.

    That’s my very quick reaction, just having seen this.

    I haven’t looked closely at your BEA analysis yet.

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    1. Back from holiday.

      "Think of historic depreciation accounting as a hedge for the required repayment of historic nominal debt incurred. If the machine is financed by debt, then deprecation allows the accumulation of cash equivalent to the required debt principal repayment. That is a return of nominal capital."

      I suppose we could think about depreciation that way. I believe the standard was of conceptualizing depreciation is as a general "using up" of capital. This using up is independent of the method of financing, whether it be debt, equity, or internally generated cash.

      "Markets are expected to look through this, including understanding the difference between profits generated from past decisions and expected future profits generated in large part by future decisions."

      That's pretty much my point. If people are characterized by money illusion, they won't be able to look through the veneer created by historical cost deprecation.

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