How Warren Buffett's Politics Prediction Came True

By Markets Fool.com

Seventeen years ago, in a passing observation, Warren Buffett more or less predicted that today's political environment was a likely product of something that investors had hoped would come to pass: significantly better corporate profit margins. Well, those bigger profit margins have arrived, and they've been a major driver of both the decent returns of the market over the past 10 years and today's economic polarization. The next chapter of both corporate profitability and the election cycle should be interesting.

Continue Reading Below

Last year I wrote quite a bit about margins, Buffett's prediction, and the economic environment. Here's a quick refresher:

  • Profit margins are really important for earnings, and in the last half of 2014 and first half of 2015, they had reached all-time highs.
  • Seventeen years ago, Warren Buffett predicted that the returns of the market would be around 7% annually between 1999 and 2015. They ended up being about 5% annually.
  • Last year, the Misery Index, a combination of the inflation and unemployment rates, was its lowest level since 1955-1956. Nevertheless, maybe not everybody is so happy.

For this month's column, let's start by setting out some data on the level of corporate profit margins achieved under presidential administrations over the past 67 years.

1948-1952

Truman

0.059

1953-1960

Eisenhower

0.058

1961-1968

Kennedy/Johnson

0.070

1969-1976

Nixon/Ford

0.054

1977-1980

Carter

0.059

1981-1988

Reagan

0.052

1989-1992

Bush

0.048

1993-2000

Clinton

0.061

2001-2008

Bush

0.071

2009-2015

Obama

0.089

Data from Federal Reserve Bank of St. Louis. Emphasis added.

Continue Reading Below

There are various ways to calculate profit margins. The specific data I'm looking at here is corporate profits after tax, with inventory valuation adjustment (IVA) and capital consumption adjustment (CCadj) divided by gross domestic product. You can use other measures, but as long as you're consistent in the terms, the trends and stability of the data should hold.

As you will note, though the chart shows a lot of ups and downs, over four- and eight-year periods for the 60 years between 1948 and 2008, there was a fair degree of stability, with everything falling between about 5% and 7%.

Let's go back to 1999, when Buffett was writing about what to expect from the stock market over the next 17 years. A large chunk of his analysis was focused on profit margins, beginning with a quick history lesson:

The second thing bearing on stock prices during this 17 years was after-tax corporate profits [referencing an included chart] as a percentage of GDP. In effect, what this chart tells you is what portion of the GDP ended up every year with the shareholders of American business.

As you can see, corporate profits as a percentage of GDP peaked in 1929, and then they tanked. The left-hand side of the chart, in fact, is filled with aberrations: not only the Depression but also a wartime profits boom -- sedated by the excess-profits tax -- and another boom after the war. But from 1951 on, the percentage settled down pretty much to a 4% to 6.5% range.

By 1981, though, the trend was headed toward the bottom of that band, and in 1982 profits tumbled to 3.5%. So at that point investors were looking at two strong negatives: Profits were sub-par and interest rates were sky-high. ...

Now, what happened in the 17 years beginning with 1982? One thing that didn't happen was comparable growth in GDP: In this second 17-year period, GDP less than tripled. But interest rates began their descent, and after the Volcker effect wore off, profits began to climb -- not steadily, but nonetheless with real power. You can see the profit trend in the chart, which shows that by the late 1990s, after-tax profits as a percent of GDP were running close to 6%, which is on the upper part of the "normalcy" band.

Buffett was using a slightly different calculation of profit margins, but close enough. Looking again at our presidential table, we see that profit margins were in a reasonably tight band both before Buffett's quote and for about a decade after. Buffett allows that profit margins could improve from the already elevated position they were at in 1999 but that you shouldn't hold your breath for it -- or at least you should consider the consequences (emphasis added):

In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems -- and in my view a major reslicing of the pie just isn't going to happen.

Here we find where Buffett was wrong, though it looks likely he won't be wrong forever. There has been spectacular growth in margins for nearly 12 years now, with a blip momentarily down during the Great Recession. Corporate investors in aggregate have been eating an ever-growing portion of the American economic pie, and political problems have been raised. We have highly competitive political campaigns on both the left and the right that are fueling Americans' anger over the uneven distribution of wealth in the U.S., which they see as unfair. And that perception of unfairness is supported by 80 years of experience.

Profit margins have already started descending from recent highs. For the most recently reported quarter, they were at 7.6%, down from their highs of 10.1% in 2011. That's in large part a function of the complete elimination of any profits in the energy sector as a whole, but the decline from the highs had started before the collapse of the price of oil. Oil prices may well recover and thereby boost profit margins for the market as a whole, but to expect margins to return to their previous heights would be to ignore the likelihood of continued political pressure for wage increases. Consider the legislation just passed in California and New York, raising the minimum wage to $15 an hour.

It is too facile to look at the extremely low levels of inflation and unemployment, add them together, note that the "Misery Index" is at highs not witnessed since Eisenhower, and conclude that our society is sufficiently happy. The division of that ever-growing economic pie apparently needs maintenance as well, and that simply isn't happening. Median household income, adjusted for inflation, is lower than it was in 2000 -- something that Buffett never would have predicted in 1999, especially given the real growth of the economy in the meantime.

You can observe a lot by watching profit margins, and that was one of the points Buffett was making back in 1999. I don't know how this election cycle will turn out, but regardless of the outcome, the pressures on corporate profit margins from the political realm are likely to continue -- and return whenever margins depart from their historical norm. At least that's what Buffett told you to consider 17 years ago. More and more, it looks like he had a point.

But be alert
No matter where or how you invest, it's always important to control your costs. That's why our team produced a special report uncovering a number of "hidden costs" you might not normally consider. It's absolutely free, and you can access it by following the link here.

The article How Warren Buffett's Politics Prediction Came True originally appeared on Fool.com.

Try any of our Foolish newsletter services free for 30 days. 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.