3 Things Worth Thinking About (Vol. 17)
["3 Things Worth Thinking About" is a weekly publication of ideas, usually contrarian, to provoke thoughtful discussions and decision-making processes. As a portfolio strategist, I am sharing things that I am considering with respect to current investment models and portfolio allocations. Please feel free to email or tweet me with your comments and ideas.]
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 rateever."
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.
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.
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.
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.
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.
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.
Sorry. No data so far.