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Where all them profits going?

I don’t plan to devote many words to current events, but this one struck me as being somewhat interesting and has been a trend for the last 7 quarters, so perhaps there is something deeper and more interesting going on here.

The nation’s workers may be struggling, but American companies just had their best quarter ever.

Corporate profits have been climbing steadily and setting records recently, while unemployment has remained stagnant. This is sometimes used as an example of how strange the market is behaving these days.

I would contend that this behavior on the part of major corporations makes perfect sense given the economics shifts we have endured, and it points to a healthy, reasoned functioning of the free markets.

When the credit markets froze during the beginning of the recession, companies that relied on the free flow of credit found significant areas of their business in jeopardy.  Without being able to freely borrow money and repay with quick turn around time (commercial paper) they found themselves unable to function efficiently.  Companies that used to be able to borrow money to make payroll if their collections were low one month realized how close to the wire they were really running their company.

The response to this tightening of credit and the realization that those companies were so dependent on the credit market is cash hoarding.  Companies are turning out record profits by keeping a tight control on expenses and continuing to do more with less in large part to shore up their balance sheets.  They want enough cash in the bank to be able to survive the market swings we are experiencing.

You may have noticed the same thing in your own household.  Keeping a little extra in the bank since you know it may not be quite so easy to go out and borrow more money.  Or even if you could borrow that money, you don’t like the idea of the bank having so much influence over your financial future.

We are the next depression era generation.  I darned 3 pairs of socks last sunday night.  I’ve never considered myself a crafty person, but the idea of saving 20 dollars by darning a pair of wool socks was pretty appealing.  I’m paying down my debt as quickly as possible, while at the same time trying to put some money in the bank.

Large corporations are doing the same thing.  The US economy was very highly leveraged 3 years ago, and now that leverage is unwinding.  Where are those profits going if they are not going to increased hiring or wages? They are going to pay down debt, and to put some cash in the bank.  The companies left are the ones that adjusted, that learned to survive in this new economy you need to be thrifty.  You can’t depend on freely flowing money anymore.

I expect to see the markets shift over the next 12 months.  Already there is more talk of startups being funded.  All this cash is good when hedging bets, but that cash in the bank doesn’t grow until you start putting it to work.

So what can we learn from this? I think the first take-away is that corporations are not behaving much different than individuals in this regard.  After all, companies are run by individuals.  Their behavior typically doesn’t stray far from our own patterns.

Secondly, this is a good opportunity to focus on the core 20%.  Without a lot of extra money, companies and individuals should be seeking to return to their core principals.  Cut out products and customers that aren’t profitable. Drop expensive hobbies you rarely have time to practice.  Darn a few socks, and make sure that next sweater you buy is going to last a few seasons.

4 Comments Post a comment
  1. Interesting observations. The only folks not following this trend of saving and streamlining is government. I think the next few years will show us whether that is wise or not.

    November 25, 2010
  2. Fred #

    I would be curious about a couple of details, like, do these profits tend to flow to larger companies? Multi-nationals? Because of acquisitions? How are the profits being used for capital investments compared to expenses? Are the most profitable companies really the frugal ones?

    November 28, 2010
  3. @Brian,
    It will be interesting to see what happens over the next 10 years. If the federal government is investing those dollars in projects that will pay dividends over the long haul, then great. Borrowing money today to build for the future can be a great investment, but if those projects are just short term stop gap measures, they may be great now, but the debt service will erase any short term benefit.

    Good questions. I was reading an article in the New Yorker tonight titled “What good is Wall Street” by John Cassidy discussing the practices of some of the larger banks, including Citibank. Some of the profits they claim simply come from their mark to market evaluations. Those aren’t necessarily profits driven from frugality, but potentially from aggressive trading and mark to market evaluations.

    It looks like the study linked in the nytimes article has some of the detail you are looking for.

    “Domestic profits of financial corporations increased $33.3 billion in the third quarter, in contrast to a decrease of $3.4 billion in the second. Domestic profits of nonfinancial corporations increased $18.6 billion in the third quarter, compared with an increase of $48.2 billion in the second.”

    November 29, 2010
  4. More information on cash balances for non-financial institutions.

    Corporate Cash: Top 20 Firms = $635 Billion

    December 1, 2010

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