Investing in a Resource-Constrained World

Arctic ice cover is at its lowest level in decades – and maybe in millennia.  All over the world, heat records are being broken, and droughts affect vast areas.  Meanwhile, conventional oil production has been flat worldwide since 2005, and despite the ongoing recession, prices remain high.

A recent study of 405 of the biggest global companies reported that 37 percent say they are already seeing the effects of climate change on their businesses, up from 10% just two years ago. The potential consequences of these conditions for society are written about frequently, but here is a simpler question that is important to our community:  How are these and related facts likely to affect investment returns going forward?  How can we even frame such questions usefully?

I’ll discuss how advisors can construct portfolios that will respond well to future resource constraints and environmental change, but first let’s consider a model that can help us explain how long-term investment performance depends on the underlying forces driving our economy.

A resource-based economic model

The easiest way to think about the factors affecting stock performance is a simple formula that works to define the overall level of stock prices in terms of other features of the economy:

            Stock Prices = GDP x Percent in Profits x P/E ratio

The first factor is the GDP – the level of production for our country.  This is multiplied by the percentage of GDP that goes to corporate profits.  The final factor is the price paid for those profits, or the P/E ratio.  For simplicity, let’s set aside dividends, stock repurchases and other sources of return for stocks, and let’s instead focus simply on prices.

This formula is an identity at the broad market level, but each of the factors can change independently:
GDP measures the level of all economic activity, including both real changes and price changes (since stock prices are in nominal dollars).  The economy grows or shrinks based on the availability and use of capital, labor, and natural resources, and on whether investment is sufficient to grow those factors faster than depletion and depreciation decrease them.   Changes in demand are the other side of the coin, since inadequate demand makes investment and production less profitable.

Profit levels are based on what share of the economy the corporate sector comprises and how much is left after expenses for compensation for labor and management, taxes and regulatory compliance, natural resources, real estate, transportation costs, R&D, interest on debt, and other costs of doing business.

Price-earnings ratios are determined by the need for capital, available alternatives for money, risk expectations, and the general outlook for growth and inflation. 

Over time, if the percentage of the GDP in profits and P/E ratios both do not change, then stock prices will generally track the overall economy.  Usually, though, those factors do change a lot, and the link between stocks and GDP is often weak.
Currently, corporate profits as a share of the economy are at an all-time high, price-earnings ratios are modestly above historical averages and GDP growth is slow but positive.

The above framework is useful for testing any general investing hypothesis.  If an investor (or advisor) believes that profit margins or P/E ratios will rise, then being long in the stock market makes sense.  On the other hand, if the overall expectation is for margins to revert to normal or P/E ratios to fall, then stock returns will likely disappoint.   A shrinking economy is usually a bad place to invest.

Using this framework, let’s consider the effects of some of the resource trends we have observed in recent years.