Just over a year ago we discussed in great detail the cyclical nature of profit margins [3], the elegance of the Kalecki (profits) equation (and its Japanese outlier real-world fallacy), and the current desire to 'invest' in dividends and not CapEx creating a vicious cycle of cash-flow-sagging aging assets. The situation has not improved.
As John Hussman notes [4], the Shiller P/E passed its 24x Maginot Line last week and yet, with revenues stagnant and earnings eking out gains, we are to believe valuations are cheap and margins will save the day. "The impression that stocks are “reasonably valued” relative to earnings is an illusion driven by profit margins that are 70% above their historical norm.
[5]
Almost universally, Wall Street analysts are making the mistake of valuing stocks on the basis of a single year of forward operating earnings, as if the present estimate is a sufficient statistic that is representative of the entire future stream of cash flows." It is not...
Excerpted from Hussman Funds - Closing Arguments: Nothing Further, Your Honor [4],
On profit margins
The facts that savings equal investment and that the deficits of one sector must arise as the surplus of another are not theories. They are identities that must hold true by accounting definition. It does not matter how companies are deriving their profits (domestically or internationally). It does not matter how consumers are obtaining their goods (domestically or internationally). It does not matter how the government is financing its deficits (domestically or internationally). It is true merely and strictly by identity that savings equal investment, and that the deficits of one sector must arise as the surplus of another.
The exact way that this comes about is up for grabs, but the end result is not. It is also true empirically in decades of data since the 1940’s that the following aspect of that relationship holds quite robustly: variations in profit margins are essentially a mirror-image of the combined deficit of households and government. This is true not only of levels, but of point-to-point changes.
Corporate profit margins will contract as the combined deficit of households and government retreats (even moderately) from the record levels of recent years. The impression that stocks are “reasonably valued” relative to earnings is an illusion driven by profit margins that are 70% above their historical norm.
[6]
Almost universally, Wall Street analysts are making the mistake of valuing stocks on the basis of a single year of forward operating earnings, as if the present estimate is a sufficient statistic that is representative of the entire future stream of cash flows.
[7]
Even profit/GDP levels much less extreme than today’s have always been followed by a contraction of profits over the following 4-year period.
In other words, we had it good but it ain't gonna last...