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3 Things Worth Thinking About

Tyler Durden's picture




 

Submitted by Lance Roberts of STA Wealth Management,

Mean Reverting Profits

Earlier this week I discussed the growing detachment between the stock market and the "real" underlying economy. One of the areas I touched on was corporate earnings that have been elevated by an immense amount of accounting gimmackry, cost cutting, and productivity increases. The problem, as I stated, is that historically earnings have grown 6% peak-to-peak before a reversion. Notice, I said peak-to-peak. The issue is that the majority of analysts now estimate that earnings will rise unabated for the next five years.

As shown in the chart below, earnings have never attained the currently expected growth rate...ever."

Earnings-Estimates-Forward-111114
 

However, this also applies to corporate profit margins as well. As Jeremy Grantham once stated:

"Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system, and it is not functioning properly.”

Grantham is correct. As shown, when we look at inflation-adjusted profit margins as a percentage of inflation-adjusted GDP we see a clear process of mean reverting activity over time.

Corporate-ProfitMargins-Reversion-111314

Reversions occur both from peaks and troughs, therefore, when profits-to-GDP have exceeded their long-term average to a significant degree (1 or 2 standard deviations) that has been a subsequent reversion.  (Note: if I use nominal corporate profits the ratio is near 2-standard deviations from the mean)

Corporate profit margins have physical constraints.  Out of each dollar of revenue created there are costs such as infrastructure, R&D, wages, etc. Currently, one of the biggest beneficiaries to expanding profit margins has been the suppression of employment and wage growth and artificially suppressed interest rates that have significantly lowered borrowing costs. Should either of the issues change in the future, the impact to profit margins will likely be significant.

However, there is one more fascinating tale that the inflation-adjusted profits-to-GDP ratio tells us. The chart below shows the ratio overlaid against the S&P 500 index. 

Corporate-ProfitMargins-Reversion-111314-2

I have highlighted peaks in the profits-to-GDP ratio with the blue vertical bars. As you can see the peaks, and subsequent reversions, in the ratio have been a leading indicator or more severe reversions in investment markets over time. This should not be surprising as asset prices should eventually reflect the underlying reality of corporate profitability. However, since asset prices are driven by emotion, rather than logic, this accounts for the lag between the fundamentals and the realization by investors that "this time is NOT different."

 

Follow The Leader

As the markets have been pressing new highs as of late, it has been interesting to note the deterioration in the breadth and leadership of the markets. Such indications are generally a sign of a late-stage market advances and should be something that investors are cautious of.

There is also the issue of what sectors are leading the markets as it relates to the current economic cycle. The chart below is a theoretical model based on Sam Stovall's "Guide To Sector Rotation" which states that different sectors are stronger at different points in the economic cycle. It shows these relationships and the order in which various sectors should get a boost from the economic cycle. The Market Cycle preceeds the Economic Cycle because investors try to anticipate economic effects; however, that relationship has become much more coincidental in recent years.

Sector-Rotation-Cycle-111314

Here is why this is important. Since the beginning of this year, as the Federal Reserve wound down its latest "bond buying" program, the following sectors are the ones leading the market.

Sector-Performance-YTD-111314

If the historical analysis holds true, then the current outperformance by Healthcare, Utilities and Staples in particular suggests that we are in the latter stage of economic recovery. Of course, considering that we are currently in the 5th longest economic recovery in history, the fact that we are closer to the end of it should not be a surprise.

Neither corporate profits margins or sector leadership suggests that the markets are about to "crash." However, it is highly likely that calls for continued "bull markets" for another decade are likely a "siren's song" leading unwary investors to their demise once again.

 

The Federal Reserve Is Targeting Another Bubble

Charlie Bilello recently posted an interesting thought - "Is the Federal Reserve intentionally creating an asset bubble?"

As he states in his post:

"Given such evidence, to believe that the Fed is targeting anything but another bubble in stock prices at this point would be an enormous leap of faith. How could one rationally conclude otherwise? Six years of easy money has unquestionably inflated asset prices but failed to have a proportionate effect on the real economy. If maintaining 0% interest rates was really about wage and economic growth, wouldn’t we have seen it by now after six years?"

He is correct. For a long time, the Fed stated that it would be appropriate to keep the Fed Funds Rate in an "exceptionally low range" as "long as the unemployment rate remains above 6 1/2 percent." However, instead of following this policy, they chose to remove that language in March of this year as the unemployment rate approached 6.5%. Today the unemployment rate is down to 5.8% and the Fed is still telling us that rates will be at 0% for a "considerable time."

This is a crucial point. While the media continues points to monthly employment reports as a sign of economic revival, the reality is far different. With 45% of the working-age population no longer counted as part of the workforce the labor slack is significant. The Fed realizes this and is why they removed their employment targets. It also undermines the headlines that only 5.8% of the population is currently unemployed.

Employment-U3-NILF-100614

So, why is the Fed playing these games more than five years into an economic expansion? As Charlie suggest:

"In plain English, they seem to be targeting another bubble in stocks. Why would they do so, you ask? They continue to espouse the belief, as Ben Bernanke first outlined in 2010, that such bubbles will lead to a 'virtuous circle' of increased consumer spending which will in turn lead to higher incomes and a stronger economic expansion."

The problem is that has yet to be the case. The reason is that consumers cannot spend first. Consumption cannot lead production. Individuals must produce first to earn a wage with which to consume. More importantly, incomes have stagnated in recent years which has further compounded the problem.

From 1980 to 2000, when the economy was growing at a higher rate, real household income increased from $47,668 to $56,800, where it peaked. But since 2000, and after two recessions, median household income in the United States has declined. In 2013, median household income was $51,939, the lowest it has been since 1995.

With inflation, albeit low, outpacing wage growth the ability to consume is diminished. With the domestic economy almost 70% based on consumption - you can easily determine the problem.

While creating a bubble in the stock market probably kept the recessionary drag from being far worse, the eventual deflation of the bubble is likely to have very serious consequences.

 

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Thu, 11/13/2014 - 15:25 | 5445385 no more banksters
no more banksters's picture

US debt held by the Fed: Just another chart

... or maybe another way to understand whether a big financial crisis is about to explode

http://failedevolution.blogspot.gr/2014/11/us-debt-held-by-fed-just-anot...

Thu, 11/13/2014 - 15:27 | 5445394 ZippyBananaPants
ZippyBananaPants's picture

I just saw a headline on MarketWatch, "market moves deeper into negative territory"  

 

????  the dow is down 4 points.  The horror!

Thu, 11/13/2014 - 15:28 | 5445401 buzzsaw99
buzzsaw99's picture

eventual deflation?

what is this, some kind of sick joke?

Thu, 11/13/2014 - 15:40 | 5445466 DerdyBulls
DerdyBulls's picture

what happen to your networth when the thing busted last time?

Thu, 11/13/2014 - 15:27 | 5445403 ebworthen
ebworthen's picture

The FED works for the banks and the 1%, so of course they are blowing another equity bubble and punishing savers.

All that money trapped in 401K's/IRA's/Pensions for the long term to be shaken down, again, to profit the banksters.

Thu, 11/13/2014 - 15:51 | 5445499 101 years and c...
101 years and counting's picture

the banksters buy low and sell high.  the peasants buy high and sell low.  wash rinse repeat every 4-5 years.  ever since the fed killed the economy in the late 90's.

Thu, 11/13/2014 - 16:03 | 5445553 ebworthen
ebworthen's picture

The banksters have several generations of savings to gamble with, and the FED at their back working the cashier window and Croupier at the tables.

Us peasants are trapped in the casino, though I have taken pleasure in cashing out my IRA.

Thu, 11/13/2014 - 15:30 | 5445425 Bell's 2 hearted
Bell's 2 hearted's picture

3 things worth thinking about?

 

how about 2 ... your calls on 10yr @4% in 2015 and USD decline (200 pips ago) ...

Thu, 11/13/2014 - 15:32 | 5445430 Bell's 2 hearted
Bell's 2 hearted's picture

WTI and Brent taking a major beating in the woodshed

 

Brent down almost 4% ... broke thru $78 ... and WTI WELL under $75

Thu, 11/13/2014 - 15:41 | 5445454 Headbanger
Headbanger's picture

CRUDE OIL GETTING CRUSHED!

TAKE A LOOK!

http://www.marketwatch.com/investing/Future/CRUDE%20OIL%20-%20WTI/charts...

THREE YEAR CRUDE CHART

http://www.marketwatch.com/investing/future/CRUDE%20OIL%20-%20WTI/charts...

 

STILL THINK THE STOCK MARKET ISN'T ABOUT TO FUCKING IMPLODE NOW!!?

Thu, 11/13/2014 - 16:05 | 5445554 KnuckleDragger-X
KnuckleDragger-X's picture

Think about how blackholes are created. First the star goes supernova with the outer layers exploding outward rapidly while the core collapses inwardly until until it crosses the point of no return, leaving behind a super massive point source from which nothing can escape. We're in the part where the outer part (the market) is greatly epanding but the core (the economy) has begun its collapse. We are approaching the event horizon while everybdy is admiring the pretty bubble.

Thu, 11/13/2014 - 16:56 | 5445747 MrButtoMcFarty
MrButtoMcFarty's picture

What ....this isn't Bullish?

Thu, 11/13/2014 - 15:35 | 5445437 Bell's 2 hearted
Bell's 2 hearted's picture

now over 4%

 

wheeeeeeeeeeeeeeeeee!

Thu, 11/13/2014 - 15:37 | 5445450 limacon
limacon's picture

"You load sixteen tons, what do you get
Another day older and deeper in debt
Saint Peter don't you call me 'cause I can't go
I owe my soul to the company store"

http://www.cowboylyrics.com/lyrics/classic-country/sixteen-tons---tennes...

Thu, 11/13/2014 - 16:13 | 5445595 Consuelo
Consuelo's picture

The other one from those good days -

http://www.youtube.com/watch?v=RN3exiuyQJc

Thu, 11/13/2014 - 15:40 | 5445458 Itchy and Scratchy
Thu, 11/13/2014 - 15:51 | 5445501 Thomas Aquinas
Thomas Aquinas's picture

Such analysis is praiseworthy and indeed there are natural forces that bring deviations to true:

"The straight line rules both itself and the crooked line"- Aristotle (De Anima 1;5)

But in our day, no analysis can be truly complete unless it recognises and accounts for the fact that all markets are substantively rigged.

"Under the Federal Reserve Act panics are scientifically created. The present panic is the 1st scientifically created one, worked out as we would figure a mathematical problem.

"Lindbergh on the Federal Reserve" by Congressman Charles A. Lindbergh, Sr. a reprint published by Noontide Press in 1989. The book was formerly entitled "The Economic Pinch" and it was originally published in 1923.

Thu, 11/13/2014 - 16:40 | 5445696 khakuda
khakuda's picture

Their mascot Krugman let the cat out of the bag after the 1990s stock bubble imploded when he said all we need now is a good real estate bubble to make things better.

Yes, they have done it again with a bond, stock, real estate and fiat currency/government debt bubble.  That was the goal all along and is still the goal.

Eventually, usually way too late, the markets figure out they have been duped and respond accordingly.

Thu, 11/13/2014 - 16:47 | 5445718 limacon
limacon's picture

This is a "Tragedy of the Commons" type problem .

The commons is the global trading community .

Without Ostrum Principles , the system collapses into a desperate hunt for relative advantages , tariff wars , etc

 

See

https://www.academia.edu/9289413/Relative_advantage_leads_to_war_

http://andreswhy.blogspot.com/2014/11/laundry-economics.html

Thu, 11/13/2014 - 17:38 | 5445932 limacon
limacon's picture

Never mind all that .

Play soccer and learn to win .

See

https://www.academia.edu/9290077/Passionate_Boots_Win_at_Soccer_

Thu, 11/13/2014 - 19:27 | 5446328 badger10
badger10's picture

I believe we are are in a deflationary cycle. The earning picture has been one of financial engineering. No other way to make money except stocks is a sure way to be cautious as a bubble is forming after six years of ZIRP. Always been told to be out of the market when everyone is long, especially when it's a programmed market. Good trading all.

Thu, 11/13/2014 - 20:03 | 5446473 q99x2
q99x2's picture

And the green shoots that took hold were of kryptonite.

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