Hussman Shows Why Record Corporate Profitability Portends Weakness Ahead
One of the key forward looking topics that so far relatively few wish to touch, is what the implications of record excess money sloshing around will mean for corporate margins. Following the past 3-4 quarters, in which corporate profitability has risen to near all time highs, surging input costs threaten to end the party short, as companies such as Dean Foods demonstrate they have little ability to pass prices through to consumers (nonetheless, they will certainly have to try eventually). But Fed aside, is there a cyclical relationship between the vagaries of the corporate profitability cycle, and broader economic growth? As John Hussman demonstrates in his most recent note, The Cliff, this is indeed the case, as "present levels of corporate profits are followed by negative profit growth over the coming 5 years." Which is why all those calling for margin expansion and S&P EPS growth may wish to reconsider: being wrong about one of the two is bad, being wrong about both means one better be a TBTF...
From John Hussman:
I've reviewed the valuation conditions of the stock market extensively in recent months, emphasizing that stocks are not a claim on a single year's earnings, but rather on a whole stream of future cash flows that will be delivered to investors over time. At present, investors and analysts who focus on simple price/earnings multiples (rather than modeling the entire stream of cash flows) are placing themselves at tremendous risk, because simple P/E multiples are being distorted by unusually wide profit margins. Part of this can be traced to weak employment conditions, which have held down wages and salaries. But there is more to the story - the rebound in profit margins also reflects a heavy contribution from financials (which may be more indicative of accounting factors than sustainable earnings), as well as the tail-end of stimulus spending.
The chart below underscores the relationship between high current profit margins and poor subsequent earnings growth. The blue line shows U.S. corporate profits as a percentage of GDP (left scale), which is currently just over 8% and at the highest level since 2007. The red line depicts subsequent 5-year growth in profits, but on an inverted right scale (higher values are more negative). In effect, it should not be a surprise if present levels of corporate profits are followed by negative profit growth over the coming 5 years. Indeed, the 2009 burst of stimulus spending is most probably the only factor that has prevented profit growth from being negative over the most recent 5-year period.
Municipal bond investors are clearly re-evaluating the prospects for additional fiscal stimulus from the federal government. Indeed, many state and local governments (as well as health and disability service providers that benefited from stimulus dollars), are beginning to talk about "the cliff" - an abrupt reduction in revenues due to the loss of current stimulus funding which has been used to bridge existing budget shortfalls. My impression is that equity investors face a similar "cliff" which they may not have adequately recognized yet.
The essential point is that stocks are much more richly valued than simplistic P/E multiples would suggest. Investors may pay a heavy price if they fail to adjust valuations for the level of profit margins. The only proper way to value stocks is in relation to measures of sustainable, long-run, full-cycle financial performance.
Full note, with many more relevant insights, here.