Global Trend

Even in normal times, it can be difficult to assess the implications of myriad trends simultaneously impacting our world. And that’s even more of a problem during the sort of extraordinary period in which we now find ourselves.

A year ago, investors were worried that we might be entering a period resembling the Dot-Com Crash or a repeat of the Great Financial Crisis. But as we explained in the May 2021 Trends issue, 2021 was nothing like 2000 or 2008. From that point, stocks went on to have one of their best calendar years ever, peaking just after year-end.

Now, as we enter June 2022, stock markets around the world are in the midst of another cyclical crisis caused primarily by the lingering effects of the world’s “politically-charged over-reaction to Covid19.”

That response, rather than the infection itself, wildly distorted fiscal and monetary policy and disrupted day-to-day economic activity.

Consider the facts.

After the initial crisis in 2020 had passed, loose monetary policy persisted and the United States was awash in fiscal stimulus injected during 2020. Therefore, when the so-called American Rescue Plan of 2021 was combined with the lingering effects of earlier stimulus programs it created too much demand at a time when ill-conceived social distancing restrictions and regulatory mistakes impaired the supply side of the economy.

Worse yet, much of this stimulus came in the form of “enhanced unemployment benefits, which discouraged a quick return to work.” And finally, when geopolitical problems like China’s latest COVID lockdowns and the sanctions related to the Russian invasion of Ukraine came on the scene, there was no way to prevent a wave of inflation which exceeded anything we’ve seen since the early 80s.

As of this writing, efforts to “tamp down” inflation have led to a surge in rates and a collapse in consumer confidence. This has left the Treasury, the Fed and private business with a difficult set of tactical decisions.

Given the pervasive lack of confidence in those now running the U.S. government, investors panicked. As of May 27, 2022, the S&P 500 was down 12.2 percent from its all-time high on January 4.

Meanwhile, the NASDAQ 100 was down roughly 22 percent over that same period. Notably, time-tested sentiment indicators showed extreme pessimism even though fundamental metrics indicate that a recession is at least a year away.

Such moments of extreme uncertainty are particularly difficult. As managers, consumers and investors, we’re each challenged to “make the most of the hands we’ve each been dealt.” The idea is to make sure that, on a risk-adjusted basis, our wealth is maximized. That means deciding whether to “follow the crowd” or “buck the trend.”

At Trends , our job is not to provide investment advice, but to lay out the pattern of evidence so you can make your own rational decisions.

That evidence falls into three categories:

1. Long-term trends including demographic patterns and techno-economic cycles; while these are poorly understood by most economists, managers and individuals, they make the biggest difference in determining winners and losers.

2. Business cycles which inevitably go from boom to bust and back to boom; these receive far too much attention from pundits and analysts. And,

3. Trends in investor sentiment which drive markets up and down each day; these trends radically impact returns over the following year or so and are underappreciated by most economists and investors.

Here at the beginning of June 2022, investors face a “crisis of confidence” caused by contradictory forces roiling the business cycle. As we’ll discuss, this medium-term turmoil is playing out within the constraints of powerful long-term trends and this is driving investor sentiment to extremes.

As we saw in December 2018 and March 2020, this can create significant opportunities for those who respond appropriately.

That’s why we need to consider the underlying realities before reacting to medium-term and short-term fluctuations.

We’ve recently begun the tenth year of a secular bull market driven by technological innovation. We’re currently approaching the middle of the SYNERGY stage of the digital techno-economic revolution, which is shown on a chart in this month’s printable issue.

The last two such bull markets ran from 1950 to 1973 and from 1982 to 2000. That’s an average of 21 years. So, at this point it’s reasonable to assume that the current secular bull market, which began in 2013, will run through at least 2033.

During secular bull markets, the game is rigged in favor of long-term investors who own great companies. On the other hand, during secular bear markets like 2000 to 2012, the game is generally rigged against long-term investors. To appreciate what’s happening, investors need to understand the theory of techno-economic revolutions.

 

The key concept is that technological innovation drives productivity, which drives affluence. An exhibit in the printable issue uses the example of lighting technology to illustrate this point.

Another chart shows that as productivity has steadily risen, so has real GDP. And just as productivity and GDP rose, so did stocks.

The bottom line is that despite occasional bouts of inflation like we’re currently experiencing, people keep getting richer, on average. Today excessive angst is caused by some people getting richer very rapidly, while a larger group languishes and sees themselves falling behind in relative terms.

The histories of agriculture and manufacturing clearly indicate that automation and operating margins are positively correlated.

 

Why? As automation increases, labor’s share of revenue tends to decrease, and as labor’s share of revenue decreases, operating margins tend to increase. The big question is whether or not the correlation between automation and operating margins applies across many industries and not just agriculture and manufacturing.

If so, the multi-faceted wave of automation now underway should lead to higher operating margins and higher equity market valuations, in the aggregate.

In manufacturing “robot density” measures the number of physical robots per 10,000 employees. Similarly, “automation density” measures software-based automation per 10,000 employees.

This wave of automation is happening at break-neck speed because of cheap capital and a disturbing shortage of labor. Compared to the roughly 25 years necessary to reach current automation levels in manufacturing, economy-wide automation could reach similar levels within the next five years due to the convergence of technologies and the increasing rate of innovation.

For example, the IRS reduced the time to complete a task from one year to 72 hours using robotic process automation from UiPath. Furthermore, the rollout of autonomous robot apps alone could rapidly increase automation density.

Research indicates that robot density in the manufacturing sector increased from 20 robots per 10,000 employees in 1991 to 176 in 2015, as shown in the printable Trends issue.

And new research from ARK indicates that automation density across all industries could increase from roughly 30 robots per 10,000 employees today to roughly 170 robots per 10,000 employees in 2025. That a level of automation density comparable to the robot density in manufacturing during 2015.

In the manufacturing sector, as robot density increased from roughly 50 to 170 per 10,000 employees, labor compensation as a percent of revenue fell by more than 10 percentage points.

Importantly, ARK’s research showed a positive correlation between automation and profitability in manufacturing. Labor compensation as a share of revenue is negatively correlated with operating margins, as shown in the printable Trends issue. And there is every reason to assume that the same relationship will hold true for the economy as a whole.

How much higher could automation push operating margins? Manufacturing’s labor compensation as a share of revenue fell by roughly 15 percentage points as robot density increased from 20 to 176. If the same relationship were to apply broadly, labor compensation as a share of GDP or national income could decline similarly during the next five years.

All else being equal, this suggests that, even in the absence of sales growth, an increase in automation could double operating margins and the enterprise value (EV) of equity markets by 2025.

But is this estimate reasonable? Automation has impacted the profitability of agriculture much more than that of manufacturing. Each percentage point drop in labor compensation as a share of revenue increased agricultural operating margins by 3.8%, more than 12 times the 0.3% in manufacturing, as shown by the slope of the lines in the printable issue.

Across all industries, if labor compensation as a share of revenue were to decline the same 15 percentage points as in manufacturing, corporate operating margins would double to roughly 20%.

What does that mean for stocks? Based on discounted cash flow models, a doubling in operating margins would double the multiple of enterprise value to sales. For example, the Russell 3000 could double its “fair” enterprise value to sales multiple from roughly 2.2 to nearly 4.5, without any top-line growth, solely because of increased profitability from automation. That’s a big deal.

How does that comport with what’s happening in the market right now?

Within every secular bull or bear market there are cyclical bull and bear markets, which are driven by the business cycle. This is what pundits on CNBC, Fox Business, and Bloomberg spend most of their time talking about. This is where recessions, monetary policy and geo-political shocks dominate.

A typical cyclical bear markets occurred from 2007 to 2009 and an extraordinarily brief cyclical bear market occurred in February and March 2020. This is where economic fundamentals come into play.

Today, the business cycle is in a nearly unique position. Various economists and pundits want to compare it to the stagflation crisis of the 1970s, the dot-com crash of 2000 or the Great Financial Crisis; but none of these is a good analogy. The closest macro-economic analogy is the period immediately following World War II.

Shortages and rising prices were everywhere. Productive capacity outside North America was damaged, while U.S. factories and personnel were going through a wrenching transition to peace-time production. Yet, after four years of super-charged consumer earnings and 15+ years of sub-par consumption, there was enormous pentup demand.

Coupled with the damaged economies of Europe and Asia, this created enormous shortages and price surges. Similarly, government debt relative to GDP was at unprecedented levels, which would not be seen again until the 2020s. Excessive regulation hamstrung business as war-related excesses remained on top of the New Deal programs.

As you would expect, managers, consumers and investors were deeply troubled, wondering whether good times were ahead or we’d see a return to the Great Depression.

While there are important differences, the Trends editors argue that the current situation is very similar to that of the late 1940s and that the outcome for stocks and the underlying economy will be similar.

A key similarity is the health of consumers. As in the postwar period, Americans today have the highest personal savings and household net worth that they’ve ever had. As a result, they are in position to spend, but they are somewhat nervous because of the high-level of domestic and international uncertainty.

In the late 1940s, the war economy including efforts to rebuild Europe and Asia, created supply bottlenecks and inventory shortages in the U.S. economy much like the post-pandemic overhang we’re now experiencing.

Then, as soldiers returned home and factories were converted to civilian production, the problem began to dissipate. We’re just now beginning to see similar adjustments to the 21st century economy and the benefits should not be underestimated.

And while the 21st century industrial base was never as depleted as what we saw by the end of the Great Depression, the current economy is having to retool for the post-pandemic context in much the same way that the postwar economy retooled for peace-time production. That’s leading to a similar surge in capital spending involving digital technologies.

The bottom line is that consumers are ready and able to spend, supply chain bottle necks will dissipate, productivity will surge because of the capital spending wave and idled workers will return to work as the great resignation and pandemic lockdowns recede into the rearview mirror.

The biggest problem is that the policies of the current administration are impeding our return to normal much like the 1940s policies related to the New Deal and World War II central planning. Fortunately, political and market forces are in the process of resolving this problem.

Given this trend, we offer the following forecasts for your consideration.

As we forecasted in our 2013 book Ride the Wave, solutions based on AI, networks, physical robots and sensors will transform almost every industry, creating new jobs and eliminating others.

By 2027, all other things being equal, average operating margins and associated earnings will double even if revenue levels remain the same. That implies a doubling in stock prices from recent levels even if revenues remain the same and price-earnings multiples remain at current levels.

History tells us that the real wages of workers using the new technologies will rise. The added automation will cause the real prices of products to fall. The lower prices will cause revenues to increase. And higher wages, revenues, profits and capital gains will mean higher tax receipts. The bottom line is that everyone involved in the economy will better off.

History suggests that certain industries and companies will automate rapidly, boosting productivity, profitability, and sales, while others will lag. Expect a handful of innovative companies to adopt automation early and aggressively, operating much more profitably than others with their results catalyzing adoption across the broader economy. And,

Fifth, broadly speaking, the only people who will be worse off are “potential workers” who choose not to participate in this automation-driven boom.