Now that the economy is finally starting to chug along–and now that the stock market has almost doubled off its lows–everyone’s bullish again.
Anytime everyone’s anything–bullish OR bearish–your alarm bells should start ringing.
And there’s an even better reason your alarm bells should be ringing: Fundamentals.
Prices and earnings.
Stocks appear reasonably priced when measured against this year’s expected earnings, but this year’s expected earnings aren’t normal earnings. They’re earnings inflated to near-record high profit margins.
In the past, whenever we’ve had unusually high profit margins, we’ve eventually returned to normal profit margins (and below). This mean-reversion has hammered earnings growth–and, with it, the stock market.
Is that absolutely for certain going to happen this time?
Of course not. Nothing’s ever certain.
But the only reason it won’t happen this time is if “it’s different this time.”
Those of you who have had the misfortune to live through the last three stock-market crashes–and any of the stock-market crashes before that–know why “it’s different this time” are described as the “four most expensive words in the English language.”
Now, bulls will argue vociferously (in a variety of ways) that it IS different this time. And you should always be happy to listen to those arguments. But given that, with respect to profit margins, it has NEVER been different this time, you should view all such arguments with serious scepticism.
Importantly, of course, profit margins and price-earnings ratios tell us NOTHING about what the stock market will do this week, this month, this year, or even next year. They’re just not good short-term market indicators.
What profit margins and price-earnings ratios have told us in the past, however, is what the stock market’s long-term returns are likely to be. And today’s combination of near-record high profit margins, combined with high P/E multiples (on normalized earnings), suggest that long-term stock returns are likely to be lousy.
Does that mean you just just dump all your stocks tomorrow?
Doing anything to an extreme with respect to portfolio management is almost always a recipe for disaster, especially when you’re managing your own money (as opposed to someone else’s money, which is what most money managers manage).
And in the current environment, when a decade or more of high inflation seems a distinct possibility, the last thing you want to do is get caught holding only cash or bonds.
So, as ever, you should maintain a diversified portfolio of multiple asset classes, including stocks, bonds, cash, and real-estate. If the stock portion of that portfolio has inflated massively in the past two years, however, you might want to consider rebalancing.
And, for planning purposes, you shouldn’t expect the stock market to deliver anything close to its long-term average return of 10% a year.
OK, here’s the story in pictures:
First, a chart from Northern Trust’s Paul Kasriel. It shows corporate after-tax profit margins as a per cent of GDP (with inventory adjustments) for the past half-century.
Photo: Northern Trust
Note that only 5 times in the past 60 years have corporate profit margins approached the levels they’re at today. And note what happened each time thereafter. (They regressed to–or beyond–the mean.)
When corporate profit margins are expanding, profits grow faster than revenue, and stock multiples usually expand (stocks track profits over the long haul).
When corporate profit margins are shrinking, profits grow more slowly than revenue, and stock multiples usually contract.
Here’s another look at profit margins, from Vitaliy Katsenelson. This one focuses on the past 30 years:
Photo: Vitaly Katsenelson
Yes, there is always a possibility that we’re in a “new normal” in which profit margins will keep expanding for years, if not forever. (Well, OK, not forever. Even the biggest bull would be forced to agree that, at some point, profit margins have to stop expanding, or profits will get bigger than revenue.)
Based on the history of the past 60 years, however, this seems unlikely. At several points in the past 60 years, it looked like profit margins had hit a new normal, only to see them collapse to the mean. And the odds are that the same thing will happen this time.
What could bring profit margins down?
Any of a number of things:
- Increasing commodity prices, which companies might not be able to pass through to end users
- Higher taxes, as federal and local governments try to balance their budgets
- Higher labour costs, as weak-dollar policies raise the cost of foreign manufacturing
- Deflation, as companies are forced to compete by cutting prices because consumer demand remains weak
- Recession. No one’s talking about a double-dip now, but that doesn’t mean we won’t eventually get one. And have a look at what corporate profit margins have done in past recessions.
If corporate profit margins stay at today’s high level for the next several years, the only way the stock market will deliver strong returns is if the market’s P/E ratio continues to expand. Again, it’s possible that the PE ratio will do this, but as the chart below from Professor Robert Shiller shows, the PE ratio is already high.
Specifically, on cyclically adjusted earnings (more on this here), today’s PE ratio is about 24X, versus a long-term average of 16X.
Photo: Robert Shiller
Yes, it’s possible that the market’s PE will stay elevated (or get even more elevated). But it’s more likely that the PE ratio will also regress to the mean.
In today’s market, in other words, we have both extremely high profit margins and abnormally high PE ratios. In all previous history, both measures have tended to regress to–and beyond–the mean.