I am going to shamelessly riff off of James Kostohryz's recent article on how the only bubble in stocks is the speculation about stock bubbles. He argued that bearishness among well-known analysts such as John Hussman and James Montier that is grounded in the supposed unsustainability of profit margins is utterly without warrant. I think that both positions contain some merit. Profits and stock valuations are unsustainable over the long run, but that long run could be decades away and there is no indication that corporate America is due for its comeuppance any time soon.
On the bear side, there are a couple of arguments. One is structural, and one is cyclical. Hussman used something very similar to the following chart to demonstrate that from a historical perspective, profits must come down from their cyclical highs. And presumably, stocks will stall out on the lack of profit fuel.
(Source: My calculations from St Louis Federal Reserve data)
On the structural side are two factors. Using the Kalecki profits equation (see Montier's "What Goes Up Must Come Down!"), these bears suggest that corporate profits have been cannibalizing savings (in the form of debt-financed consumption) from the household and government sectors, and that once that over-consumption (being propped up by the government at this point) finally hits the tipping-point, stocks will stall out on the lack of profit fuel. From a simpler perspective is the notion that profit margins are unsustainable beyond the 6% range, a level we passed a long time ago.
(Source: St Louis Federal Reserve)
On a long-term basis, profits appear to be "high." I put "high" in quotes, because I frankly don't know what that means. It does not look good, but without anything to account for that change, it is impossible for me to say how long that elevated level could be maintained. Obviously, the trend is unsustainable. Profits cannot rise as a percentage of GDP indefinitely. But, I have a very hard time--and I suspect that most analysts do, too--coming up with a specific level that is demonstrably unsustainable or even in what way high profits are necessarily bad.
As for the Kalecki equation specifically and what it might say about profits, I am simply too dense to form a coherent opinion on it. As Cullen Roche pointed out last month, there are "a lot of moving parts" in it. Certainly, the tremendous rise in the current account deficit (NETFI/GDP) and the fall in government and household savings coincides with the trend in corporate profit margins. Beyond that, I don't know how much can be said.
Either way, the real question is why we should believe that the tensions identified by the bears will unravel within, say, this decade. What will the catalyst be? How can we identify it?
In other words, whether one takes the bear argument at face value or simply as a disconcerting aspect of the market, to aggressively employ it requires one to grant it a degree of precision and specificity that it cannot claim. The 6% level of profits/GDP, a rule laid down by Buffett himself, has been flouted by the markets and by Buffett. Now that we are through the looking glass, what might be a reasonable estimate for how long this sort of trend can be maintained? One year? Five years? Ten years?
And, what if the market simply heals itself? What if profit margins were to ease by a resurgence in real GDP growth? Or, what if a P/E-led wealth-effect allowed households and governments to continue to spend? The correlation between the earnings yield (the inverse of the P/E) and government deficits is pretty strong.
So, Where Is the Bubble?
The bearish case plays on an obvious intuition about the markets (profits are too high, yet times are hard) and combines that with a sophisticated model. It sounds like the perfect storm for a bad trade.
I say that while at the same time remaining largely sympathetic to the overall argument. If I look at a broad set of metrics, all I can see is over-extension. Look at the ratio of S&P 500 earnings to GDP. It has clearly risen off of a very long-term trend. Stocks, on the other hand, apart from secular undulations, have moved horizontally rather than evincing the much more diagonal trend of earnings.
(Source: Shiller, Measuringworth.com)
And, as Kostohryz pointed out, stock P/Es have tended to be higher over the last fifty years compared to the ninety years prior to that. I interpret that to mean that stocks are structurally "bubbly." That is, beyond, the ups and downs of the Shiller P/E, for example, stock valuations appear to have an upward trajectory that is unsustainable. But, I don't know of any way to predict when that structural bubble--if that's what it is!--might lose momentum. If it's gone on for fifty years or so, why not twenty-five more? If P/Es went to 54 a decade or so ago, why not 75 in a decade from now? Is that too high? How about 65? Where exactly is the upper bound?
Over the last year, I have been attempting to trace the size and scope of the structural changes markets have gone through over the last century. The reader can feel free to assume that I am perfectly biased, but every change in the behavior of stocks, bonds, equities, inflation, and unemployment points to a systemic transformation closely linked to the monetary order, from the foundation of the Fed to the closing of the gold window.
I assume that a major consequence of the Federal Reserve's mission to provide "elastic money" is to effect not least of all the finance sector. Below is a chart comparing financial corporate profits relative to nonfinancial profits. At the cyclical and secular levels, the relationship between nonfinancial profits and the P/E ratio appears to be inverted, while on a structural plane, the P/E ratio appears to be positively correlated with financial profits. The spread between nonfinancial and financial profits is strangely similar to the P/E ratio since the Great Depression, so that when financial sector profits briefly exceeded nonfinancial profits in the late 1990s, the P/E ratio hit it's all-time annual high. In other words, it is the difference between financial and nonfinancial profits that seems to have a closer relationship with the P/E than does the sum of profits.
What is new in the current instance, however, is that nonfinancial profits are returning to a historically high range while the financial sector creeps back up to record highs. At the moment, the stock market appears to be content with this state of affairs in a way that it hasn't been since before the Depression. If the last century or thereabouts have been much of a guide, this current bull market will eventually see nonfinancial profits soften while financial profits slowly accrue. If not, an interesting change to an already strange relationship is underway.
(Source: St Louis Federal Reserve, Shiller, Measuringworth.com)
Whatever the precise relationship might be between these factors, the one thing that really sticks out is that, contrary to the notion kicked around about high profit margins being bad for equities, with respect to the nonfinancial sector, high profits appear to be just as likely to be bullish as bearish.
Perhaps it is in the nonfinancial sector where the notion that competition and investment can drive down profit margins ultimately functions while in the financial sector a Minsky-esque dialectic operates. That is, perhaps the distinction between the financial sector and the goods sector in terms of their reactions to supply and demand works on the level of profits rather than prices, as discussed in previous articles.
In any event, what ultimately drives prices for goods and financial asset valuations remains a deep mystery. That cannot concern us here.
The Importance of Being Attentive
My bias is always tilted in favor of the understanding that markets are being somehow distorted, and so every bet requires one to cut the baby in half, if that's the right metaphor. Side with what is ultimately sustainable and reasonable (whatever you think that might be) or with what is unsustainable and improbable. I don't know if there is a right or wrong answer to that choice. The former requires both you and Mr. Market to be intelligent and sensible. The latter choice requires you to be attentive--attentive especially to what Mr. Market does rather than to what he says.
For investors with rather long-time horizons, unsustainability and unpredictability indicate a relatively simple diversification amongst assets hard and soft. The shorter the time-horizon, on the other hand, the less dogmatic one can afford to be. Theoretically pure arguments about the connection between stock prices and earnings are as likely to go against you as for you.
That brings me back to the cyclical argument that Hussman and others have made. He indicates that a cyclical rise in profit margins is linked to a future fall in profit growth. That seems to me a somewhat similar argument to the one I have made about profit and interest rate cyclicality. I can accept, therefore, that the extraordinary momentum in earnings since the crisis is unsustainable.
But, when I look at how these cyclical downturns in profits relate to stock returns, the connection is surprising. Stocks certainly seem to react to falling profits, but roughly half of the time, it is with heightened enthusiasm, and the other half of the time, it is with a downturn. The only way that I can come up with to distinguish which one will happen is to determine the secular mode of the market. If stocks are in a secular bull market, cyclical reactions to falling profits are inversely correlated (i.e., stocks rise when profits slow); during secular bear markets, stocks are "rational," falling alongside profits. If profits and interest rates accelerate during secular bull markets, stocks can fall (e.g., 1987), but generally they remain positive if less ebullient.
In sum, as much as I share the bears' concerns about the gravity of the structural problems in the markets, the theoretical propriety of their position feels less convincing than the mercenary, unprincipled calculations about cyclical and secular behavior that are necessary in our brave new world of central banking and dollar hegemony.
The historical behavior of markets suggests that we are in secular bull market in equities (SPY, DIA) and a secular bear market in commodities (GSC, SLV, GLD) and that inflation and unemployment will tend towards the downside. Call it a "bubble" if you like, but that word, and its association with unvarnished gullibility and chicanery, does not properly capture the magnitude or nature of the worrying divergence in stocks and earnings over the last half-century.
In the meantime, it is important to distinguish between cyclical, secular, and structural factors when it comes to making investment decisions. Hussman and Montier appear to have identified a structural issue but given it cyclical significance; at the same time, Hussman has put his finger on cyclicality in earnings while neglecting the complex relationship between stocks and earnings at a cyclical frequency. The cyclical and secular indicators are all 'green', while structural conditions appear to be 'yellow' insofar as they are in a long-term but unsustainable bullish trend.