January 03, 2006,
A recent article in USA Today lamented the lack of investor returns in 2005 outside of energy stocks and Google shares. To wit, while S&P 500 earnings are up nearly 50 percent since 2000, the index remains 20 percent off its high.
What’s going on? Although earnings presumably belie the S&P’s price, the index’s performance becomes more explainable once the nature of those earnings comes into full view. In the last quarter alone, S&P earnings rose 16.1 percent. But that same number falls to 10.4 percent when you strip out the earnings of oil companies. While the latter result might at first glance seem unimportant, it becomes very important when you take into account the history of government reaction to commodity profits worldwide.
Forbes writer Kerry Dolan put it best in a recent article, noting that if “you drill a dry hole, the money you lost was yours. If you make money, the government declares that it is a windfall and snatches it.” Dolan laid out a chronological history of oil company seizures and earnings expropriations, including those engineered by the Soviets in 1917, Iran’s nationalization of the predecessor to British Petroleum in 1951, and Jimmy Carter’s imposition of a “windfall tax on oil profits” in 1979.
An optimist might think governments have learned from past mistakes, but in 2002 the United Kingdom raised the tax levy on oil companies from 30 to 40 percent, followed by tax increases in 2005 on commodity producers in Venezuela, Bolivia, and Chile. This past November, the heads of the five major U.S. oil companies were hauled before Congress to explain their profits, and while an explicit windfall profits tax was not imposed, a rule change on inventory valuation that would cost oil companies $4 billion was entered into the current Senate tax bill.
The political reaction to oil-company profit margins of 9 percent is particularly remarkable considering how companies such as Google, Dell, and Apple are frequently lionized for achieving much greater margins. Forbes publisher Rich Karlgaard has said that Google’s web-search business is powered by “100,000 cheap servers.” Along those lines, if California or U.S. taxation/regulation ever becomes too onerous, Google can abandon its cheap physical assets and take its mind innovations elsewhere. Similarly, Dell is not valued highly for its computers, but for the process by which it sells computers. That process can be taken anywhere, whereas oil cannot.
The Nasdaq index is still 55 percent below its 2000 high. One effect of this can be seen as a greater share of worldwide capital moves from the metaphysical economy (what the late Warren Brookes called “the economy of the mind”) to the physical. Though it’s not spoken of much in the major media, this capital shift towards tangible resources would logically impact stocks negatively. Canadian economist Reuven Brenner explained the phenomenon in his 2001 book, The Force of Finance. Brenner opined that a saving grace for Hong Kong has to do with it having nothing in the way of natural resources. Because it lacks resources such as oil, copper, and gold, the government there has no territorial claim (think taxation) on what makes it prosper. If the government ever did try to redistribute wealth in Hong Kong, the skilled workers would simply disappear. Applying Brenner’s logic to today’s rising commodity profits, assets “of the earth” can more easily be taxed and regulated precisely because they’re stationary and can’t escape the greedy hands of legislators. In the extreme, stationary assets can be nationalized, and there are numerous instances of this over the last 100 years.
At present, the various commodity indices are trading at all-time highs. Inflationary implications aside, the history of commodity profits is not a pretty one, and this might go far toward explaining why broad share-price indices have not caught up to their underlying earnings.
John Tamny is a writer in Washington, D.C. He can be contacted at email@example.com.