The Fed Model and Profit Margins

Vitaliy Katsenelson's picture

Last week in Institutional Investor article I've shared some important but quite boring topics that include the Fed Model, the price-to-earnings ratio, and profit margins. I imagine for most civilians (people who don’t do investing for a living) reading about these topics is as exciting as watching a live debate between two paleontologists about how the size of tyrannosaurus’ front teeth relates to the length of spinosaurus’ tail. (I have no idea what I just wrote.)

I will have you know, however, that the Fed Model is extremely important, because I vividly remember how low interest rates and the Fed Model were used as propaganda tool in the late ’90s to justify the stock market’s “this time is different” sky-high valuafed-change-interest-rate-1tion. Low interest rates have been pushing investors into riskier assets and have thus resulted in higher valuations, but just as you would expect a finite boost of energy from 5-Hour Energy drink, low interest rates will not bring permanently higher valuations in stocks.

I see an army of experts on business TV – and non-experts in day-to-day dealings – justify holding otherwise overvalued stocks by comparing their yields of 2% or 3% to the yields of bonds. Stocks and bonds are competing assets, so a low yield in bonds in the short term (a key distinction) will drive higher P/Es (lower earnings yields) in stocks. But today, rather than a race to the top we have a race to the bottom. As bonds yields rise (or not – if they don’t it means we’re in deflation, which is even worse) stock valuations will return to their rightful place – lower. Of course there is a caveat: they may go a lot higher before they do that. But that’s investing for you.

I have written the topic of profit margins half to death; I even penned a scribble for Barron’s, discussing them back in 2008. All you have to do is look at the historical charts (see this chart) – profits always mean-revert. Mean reversion of profits is so banal it should be taught in finance classes just as Newton’s law of gravitation is taught in physics. Earnings have never grown at a faster rate than GDP (sales of the economy) for a substantial period of time. This time is not different. I’d buy an argument that the long-term mean of profit margins may have shifted upwards over the last two decades as we have become more of a service and less of a manufacturing economy. So instead of being at 8% – or maybe it should be closer to 9% – we are in the mid-teens.

Vitaliy N. Katsenelson, CFA, is CIO at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).

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disabledvet's picture

"we've been saying this for five years" and "welcome aboard."

point being we've been flying in the face of reality for five straight years.

it's not a question of explaining the Depression...but the boom.
I have explained it by looking at the dollar bill and reading the part that says "Novus Ordo Seclorum."

Renfield's picture

<<low interest rates will not bring permanently higher valuations in stocks>>

Vitaliy, I am memorising this sentence. It's pithy, clear, and fits into a 5-second listening span. It connects stock valuations with interest rates, something that I don't think even occurs to most sheep.

Anyone who learns this lesson knows most of what they need to about the equity markets at this point.

I look forward to real valuations, after the structure falls over on itself. It'll be instructive then to see how much (or any) real value each of us holds.

<<Mean reversion of profits is so banal it should be taught in finance classes just as Newton’s law of gravitation is taught in physics>>

A lot of things should be taught in finance classes that aren't. I think this sentence covers a lot of ground too.

Great article: both educational and brief. 5 of 5 from me.