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1 Milestone for Equity Traders, 1 for Investors

By Alex Dumortier, CFA – Mar 30, 2016 at 11:40AM

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The VIX Volatility Index falls to a new low for 2016; meanwhile, labor scores a victory over capital -- is it the start of a broad trend?

Corporate profitability could be poised to fall. Image source: Lending Memo, republished under CC BY 2.0.

U.S. equities are slightly higher in late morning trading on Wednesday. The S&P 500 (SNPINDEX: ^GSPC) and the Dow Jones Industrial Average (DJINDICES: ^DJI) (DJINDICES: $INDU) are up 0.59% and 0.68%, respectively, at 11:30 a.m. ET.

Today produced another milestone in the stock market's recovery following a rocky start to 2016: The CBOE Volatility Index, or VIX, which is commonly referred to as Wall Street's fear gauge, plumbed a five-month low this morning, falling 3.5% to 13.33 (the previous intraday low of 12.80 dates back to Oct. 28).

The VIX reflects option traders' view of 30-day volatility for the S&P 500 index. Back on Oct. 28, the S&P 500 had rallied 11% from a sub-1,900 low a month earlier. Similarly, as of 10:25 a.m., the index has gained 13% from its Feb. 11 low.

An article in The New York Times trumpeted yesterday: "Victory for Unions, as Supreme Court, Scalia Gone, Ties 4-4," explaining:

The Supreme Court handed organized labor a major victory on Tuesday, deadlocking 4 to 4 in a case that had threatened to cripple the ability of public-sector unions to collect fees from workers who chose not to join and did not want to pay for the unions' collective bargaining activities.

While the article focuses on the pivotal impact of Judge Scalia's disappearance on this case, I wonder if it might not be a symbolic victory announcing a broader shift in the balance of power between labor and capital in favor of the former.

Indeed, corporate profits currently represent a significantly above-average share of gross domestic product, which has tended to be mean-reverting in the past (i.e., periods of above-average values usher in periods of below-average values). Similarly, the S&P 500's profit margins are historically high.

At the beginning of the month, Goldman Sachs senior U.S. economist Elad Pashtan penned a note warning investors that corporate profitability is poised to fall:

We may be on the cusp of a more broad-based margin squeeze. Our model of National Income and Product Accounts suggests a moderate decline in 2016-2017 as stronger wage growth is likely to redistribute income away from capital owners and back toward labor ...

The interdependency of compensation and output suggests a close link between wages and profit margins. Indeed, as wages accelerate above core inflation -- a proxy for output prices -- profit margins have correspondingly declined (assuming no changes in labor productivity).

If a shift comes to pass, is it a genuine problem for equity investors? It depends on your definition of "investor." Within a two- to five-year time horizon, falling profitability would certainly represent a headwind for stock prices. However, if one takes a longer time horizon, seven to 10 years or longer, say (which is more appropriate, given the nature of equity capital), it need not be a cause for concern.

After all, this is likely to just be part of a cyclical tussle between labor and capital -- "cyclical" being the operative word -- with little to no impact on the rate of long-term earnings growth.

Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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