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If you are at all concerned about slowing capital expenditures (or capex), you might want to hear what financial markets' strategist Ray Dalio has to say on the subject.

Dalio is founder and chief of

Bridgewater Associates

based in Westport, Conn., which oversees $31 billion for institutional investors. He is a big-picture guy who has always been helpful when thinking about the bigger economic trends. Even in choppy markets like these when trading can juice an investor's performance, it pays to listen to Dalio on the deeper currents that move markets.

Dalio is a self-described "moderate bear." He expects a "negligible real return on U.S. stocks.

after accounting for inflation" Why? Because in his view the investment boom that has driven the bull market since 1994 is "unsustainable."

Bridgewater's analysis, which owes a great deal also to Bob Prince and Kent Peterson, goes like this. Since 1994, the U.S. economy has been driven by one of the great investment booms in U.S. history. Business fixed investment rose 90%. Corporate profits did better, rising 150%. And stock prices, no surprise, did best, charging ahead 200%. (The P/E on the

S&P 500's stock index rose by about 20%; even if P/E's had remained the same, stock prices would have rallied 150% in the time period.) In short, earnings growth is the main reason stock prices have roared ahead.

The problem is, says Dalio, that the three big drivers that boosted profit margins cannot keep on indefinitely. Those are: increasing business investment, declining interest expenses and a thinner share of the economic pie for labor.

By new investment, Dalio means fixed investment beyond what is needed to replace worn-out capital equipment. New investment boosts earnings growth in the following. Businesses get a quick pop in revenue while the costs associated with the new cap ex get capitalized and thus shoved into the future. For instance, if




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a new router, Nortel recognizes the revenue right away while priceline depreciates the router over time and therefore books only a small fraction of the cost of the router.

Multiply this many times throughout the corporate sector, and you can see how a sustained investment boom of the likes we have seen since 1994 creates a surge in reported profits, too. The expansion in profit margins then leads to higher stock prices and more capital flowing to the Ciscos of the stock market. But, according to Bridgewater, when the boom stops accelerating -- as it undeniably is today -- profits slow as back-end expenses rise faster than the front-end revenues. That obviously is not good for stock prices. And the growth of new investment, defined as capital expenditures minus depreciation, could fall quite a ways because we are today at levels not seen since 1980-82.

The second big driver of corporate profit margins, says Dalio, is interest costs. Interest expense as a percentage of revenue has been fairly stable since 1993. That boosted profit margins. Now, we see that interest burdens are starting to rise again; net debt of U.S. nonfinancial companies as a percent of revenue has been rising rather steeply since late 1998. Again, that is bad for future profit growth and by implication stock prices.

The third boon for profit growth has been the fall in labor costs as a percentage of revenues. The percentage going to labor is near its 40-year low, says Bridgewater. Dalio foresees a "reversion to the norm," which could crimp corporate profits ahead. A win by


certainly would push in this direction. A


victory would slow such a trend, all things being equal. But, in any event, we may see the pie divided more in favor of labor, says Dalio, who cites the recent increase in real wages as evidence.

In a recent report, Bridgewater calculated that this trio of profit enhancers accounts for 86% of the variability in margins over the past 40 years and "fully explains the growth in profits since 1993. ... During the current investment boom all three of them: a) started at low levels, b) rose substantially and c) are now at high levels. Given this, extrapolating past earnings growth into the future seems dubious. Such profit growth would require a continued expansion of margins. This, in turn, would require some combination of a further acceleration in new investment despite a relatively tight

Fed policy and diminished availability of dot-com equity financing, falling interest burdens despite rising debt levels, and rising margins on labor despite extremely tight labor markets. The odds of such an event seem low. The opposite seems more likely."

Brett Fromson writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He invites you to send your feedback to