I have been banging on about profit margins for the past month, ever since I predicted 2012 would be an inflection point toward S&P500 margin compression last month. A lot of people are coming out in defense of this idea. So last week’s weekly was on this topic as well, quoting from James Montier and Richard Bernstein, who have hopped on this mean-reverting margin bandwagon.
Today I caught John Hussman making similar points:
Simply put, there is presently a massive difference between short-horizon earnings measures and longer-term, normalized earnings measures.
What’s going on here is that profit margins have never been wider in history. But profit margins are also highly cyclical over time. The wide margins at present are partly the result of deficit spending amounting to more than 8% of GDP – where government transfer payments are still holding up nearly 20% of total consumer spending, and partly the result of foreign labor outsourcing (directly, and also indirectly through imported intermediate goods) which has held down wage and salary payouts. Indeed, the ratio of corporate profits to GDP is now close to 70% above its long-term norm.
I suggest that you read the whole thing here (A False Sense of Security) but let me make two quick points before you do first.
- Margins overshoot to the downside too. Remember, this isn’t a case where margins rise and then fall back to trend. They overshoot in both directions and it is the unanticipated overshoot to the downside that creates secular bear markets since both margins and P/E ratios overshoot at the same time. It is exactly the same train that got us a bull market, but this time in reverse.
- Margins can stay elevated for longer than you think. Stimulus is key here. But the main takeaway here is that we could have made the same points about margins being cyclically high in 2010 or 2011. And we did! I certainly did in 2010 and I remember referencing some writing by David Rosenberg making similar points then. The key thing to be alert to then is that this mean reversion takes time and the ‘record high’ margin can and does continue until cyclical factors force it down. Repeatedly, we have seen the US economy stumble as a result of those factors. And each time government intervened.
Bottom line: watch the tape. If S&P earnings surprises are starting to mount quarter on quarter, you’re going to want to sell and start taking an even more aggressive defensive posture. The surprises are already mounting but not yet enough to confirm the trend.