E-piphany

I saw a chart a few weeks ago, which someone sent me from The Daily Shot. It has been bothering me since then. Here’s the chart:

Well, it looks amazing and a great reason to invest in global equities, right? Global earnings are surging due to the AI revolution![1]

What bothers me is the simple phrase which is the title of this article. I completely understand that the leaders of the exploding AI industry are going to have drooling analysts projecting great earnings growth far into the future. That may even be correct. But if a company is making bank because their AI tools are tremendous, and their revenues are surging…it means that other companies are paying for that product and so revenues and expenses should net across the corporate landscape. This is not only true of AI, of course; big earnings of oil companies are offset by added costs for businesses and/or declining revenues for other companies selling to consumers with less ex-energy discretionary income.

That is probably the reason that, most years, forward estimates start out high because we can see the concentrated winners clearly but then decline gradually as the dispersed losers become plain. But that doesn’t seem to be happening this time. In fact, it seems like both sides are claiming gains from AI: the suppliers who are selling it, and the buyers who analysts think will show remarkable gains from using AI.

This is a great moment to review again Brad Cornell/Rob Arnott’s “The ‘Basic Speed Law’ for Capital Markets Returns“. I wrote about this most-recently in 2024, in “AI: Even a Big Deal is Smaller Than You Think.” The upshot of their ‘Basic Speed Law,’ which has held up remarkably well over time, is that real earnings cannot grow much faster (or slower) than the growth rate in real per capita GDP. So, unless we decide that AI is going to accelerate per capita GDP growth drastically – and as you can tell from the link to my prior article, I don’t buy that – we need to be skeptical about forecasts of huge earnings growth rates.

Now, a 100-year chart can hide a lot of deviations in the average. The basic speed law here is grounded by fundamental accounting identities. GDP is total expenditure on all goods and services, so it makes sense that total corporate revenues (and expenses) should be pretty highly correlated to that figure. So if the share of that expenditure that is profits increases – which is what the analysts are saying is going to happen – then something else needs to be true:

1. Margins – and in this case global margins – need to expand as companies take more money from labor (if revenues minus costs go up, and revenues are constrained by GDP, costs need to go down and there’s only so much you can do with materials costs). But at least in the US, margins have been historically wide for some time. NIPA profits as a percentage of GDP are in the 12% range, which is already almost double of what it was pre-GFC. How much can this go up? Populism is already on the rise.

2. Government spending can increase – this is another way to extract money from others, and that is to get the government to buy your stuff and sell debt to get the money to pay for it. Government deficits are part of the Kalecki equation. However, at least in the US the government deficit is shrinking. This might not be true this quarter since the US had to refund huge amounts of tariff revenues, but the general trend is towards better balancing of US trade and fiscal deficits.
3. Consumers can spend a higher percentage of their income, and save less. This is also part of the Kalecki equation, and indeed personal savings have been declining. Over the last two years, the decline in personal savings has been the source of about 90% of the rise in corporate after-tax profits. See the chart below showing net corporate profits versus net savings (inverted, right scale). So…how much less can Americans save? Currently, savings is 2.72% of GDP. The last time it was lower (with the exception of right after COVID when people were spending their stimmy checks) was 2005-2008. And that was the all-time low of 1.5-2%. Before COVID, we were around 5%. Back in the early 1980s when interest rates were more attractive, savings was more like 7-8% of GDP.

4. US companies can increase revenues and profits at the expense of non-US companies. That doesn’t really help us with the chart at the top of this article, which is global.
5. Public companies can make hay at the expense of private companies. I totally believe in this one, since I manage a private company that is perpetually running into rule systems put into place to protect the big companies. But it doesn’t square with the AI promise, nor the fact that new business formation is robust and has been so for several years…and does not appear to be ebbing. These could all be profitless businesses – but now you have to explain why profitless businesses are exploding.

6. Earnings per share could be increased by decreasing share count. That’s been the game for many a year, adding several percentage points to EPS growth by decreasing the “S”. There are some suspicions that that trend is reversing, with a lot of high-profile IPOs throwing a lot of shares onto the market. I don’t have good data on that. But I doubt that share buybacks are increasing.
7. An increase in overall leverage, either financial leverage (debt/equity) or operating leverage (more fixed costs), could cause forward earnings growth to look better. It is instructive that over the last hundred years – looking at the ‘speed law’ chart – the gradual, pervasive increase in both forms of leverage has been associated with only a tiny acceleration in profits growth over time. I do think it has been a factor, but additional leverage is not freely available without bound. However, this might be part of the story – not because leverage is increasing broadly and suddenly, but because the composition of the indices is shifting to more high-margin and high-operating-leverage (but interestingly, very low-financial-leverage) businesses. Still, that doesn’t really explain the upward scoop in the global indices that cover a huge number of companies. Even accounting for the fact that those indices are generally market-cap-weighted, it seems far too large an effect to be mere substitution.

In short, while I think parts of these explanations have a kernel of truth to them…I think a lot of what we are looking at is analyst myopia. Analysts are focusing on the shiny objects of great worth, and are missing, for now, some of the offsetting effects on other companies. It may be possible for those earnings estimates to even be realized, if enough revenues are shifted temporally relative to costs (exciting companies realize the revenues now; boring companies capitalize the AI expenditures or defer the costs to later quarters). Sooner or later, though, it all must add up. Right now, in my mind it doesn’t seem to add up.

[1] As an aside, for much of the rest of this article I will refer to the US case. Not only is the US contribution to these earnings the largest by far but also – if the source of the surge is AI, then the US is where we would expect that surge to be sourced. I just mention this here because someone will noted the disconnect between this global chart, and the commentary based on US trends.