Stop me if you've heard this before:
The market is dangerous because corporate profit margins are at record levels. When they inevitably contract, the market will appear too expensive and justify a crash, bear market, or most devious of all, a secular range-bound market.
This was an argument that I first heard from the great and powerful Jeremy Grantham. The basic idea emerged a few years ago, and as the thesis has circulated and changed forms, the underlying condition has only grown more extreme.
FRED even features CP/GDP as one of their built-in transformations now.
The data is incontrovertible, of course. U.S. margins are huge right now and corporate profits as a percentage of GDP are at the widest level they've ever been.
I continue to believe that if you're in the bear camp, this remains one of the better pillars around which to build your investment case. At some point, theoretically, competition will emerge and the earnings power of the companies behind this phenomenon will erode.
I don't consider myself as a member of that camp for reasons we'll get into in a moment. But I am fascinated and obsessed by this notion that we are, today, living in a very unique slice of history, one that cannot be sustained and will only finally give way once a critical mass of individuals truly believe that it can and will be sustained for all eternity. It is an amazing time for U.S. corporations right now, and basically none of us saw this coming back in the depth of the crisis.
The market hasn't done it without a little help, of course. Part of me wonders if we're all simply participants in a grand cosmic experiment to see what happens when we take real rates to zero pretty much everywhere on the planet and leave them there for a long, long time. Just how much risk can we all be incentivized to take? And how much legitimate economic awesomeness can we cultivate in the meantime?
Those are questions without answers. In the meantime, the best we can do is look at today's fundamental data and relate it to the past.
Corporations are undoubtedly eating a record share of the total U.S. economic pie, but a lot of that has to do with the fact that it's now a globalized world. A large percentage of these profits are derived from overseas.
Along those lines, the current situation doesn't seem so historic.
I'm not exactly panicked by that, are you?
Sure, it's at the higher end of that historical range, but it's still well below the crazy days, and there are a lot of reasons why one might expect U.S. corporations to have a bit of an advantage over the rest of the world right now, not least of which includes a very favorable regulatory environment. Plus, that data set reflects the more commonly used after-tax corporate profits.
We know that another one of the factors contributing to this era of massive corporate profitability is an environment of historically low corporate taxes.
We all know about this chart, too:
U.S. corporations are forking over a historically small share of their profits to the government. This shouldn't surprise you, since they're basically the ones that are writing all the regulations. It's hard to talk about having a "bought Congress" in this country without sounding like a bit of a conspiracy-driven wacko. But literally every data set out there supports that conclusion in either a direct or indirect way. Our government and public policy is more or less a tool for the companies that dominate the economic landscape.
You can probably guess at the next conclusion. Should the tax environment ever get less favorable in this country by way of changing policy, it could have a fairly substantial impact on the U.S. equity markets. Who in their right mind, tinfoil hat or not, would make that bet?
As we return to our basic thesis, look at what happens when we go back and relate pre-tax profits to global GDP.
I'm even less concerned that the earnings underpinning the market right now are outsized or inherently unsustainable. Maybe not totally unconcerned, because, with the exception of the pre-crash days, U.S. corporate profits are still the highest they've been in 20 years. It's just not as historic a skew as it seems from other perspectives and the current regulatory & tax environment don't pose a meaningful threat.
With this type of framework, it's considerably more difficult to make a point that some sort of corporate profit-based mean reversion is on the horizon.
Yes, corporate profits are huge right now. But relative to the growth that the entire world has experienced, U.S. profits represent a fairly normal percentage of that. The U.S. corporate world is arguably less important to the global economy that it was in the 1960s and 70s. And profits still have considerable room to run before they threaten the pre-crash peak -- not that they should make a run at that, mind you. If anything, looking at this revised indicator back in 2007 should have caused us to wonder if something really crazy and unsustainable was afoot in the U.S. corporate landscape. It was a reminder that leverage really had gotten out of control.
The bigger point here is that analyzing current market valuations isn't just about normalizing earnings or relating them to GDP. As always, there's a bit more to the discussion. We need to take a more nuanced view.
Ultimately, we still do need to ask a really important question: what do you really believe will happen with corporate earnings? Do you think they'll keep growing? How big can those corporate profits grow? Will they just flatten out up here and stay in a range? Or will they retreat towards some modern-era mean?
The only sensible answer is "we can't say for sure." But he who guesses correctly stands to make a lot of money in the next 3-5 years.
In the meantime, let's focus on a few other things that we do know as we work our way towards an actionable strategy.
The Only 20 Companies that Matter
One of the things that is fairly easy to get a handle on is a simple list of the most profitable corporations. It's a decent place to start. I used the most current data I could find (the latest Fortune 500 list) so this list looks a little different than it did last year and will look different again the next as more recent year's profits are included. Individual earnings are always shifting, loose shards of talus upon which we try to erect our base camp.
|Company||Profits (after tax)|
|Exxon Mobil (NYSE:XOM)||$45 billion|
|Apple (NASDAQ:AAPL)||$33 billion|
|Chevron (NYSE:CVX)||$26 billion|
|JPMorgan (NYSE:JPM)||$22 billion|
|Wells Fargo (NYSE:WFC)||$19 billion|
|Fannie Mae (OTCQB:FNMA)||$17 billion|
|Wal-Mart (NYSE:WMT)||$17 billion|
|Microsoft (NASDAQ:MSFT)||$17 billion|
|IBM (NYSE:IBM)||$17 billion|
|Berkshire Hathaway (NYSE:BRK.A)||$15 billion|
Per FRED, over the same time period, total U.S. corporate profits after tax was $1,796 billion.
So that means that those ten companies represent a staggering 12.6% of total U.S. corporate profits.
But hold on, we're not done yet.
If you include the next 10 names, it gets even more interesting.
|Company||Profits (after tax)|
|Pfizer (NYSE:PFE)||$15 billion|
|General Electric (NYSE:GE)||$14 billion|
|Intel (NASDAQ:INTC)||$11 billion|
|Freddie Mac (OTCQB:FMCC)||$11 billion|
|Johnson & Johnson (NYSE:JNJ)||$11 billion|
|Procter & Gamble (NYSE:PG)||$11 billion|
|Google (NASDAQ:GOOG)||$11 billion|
|Oracle (NYSE:ORCL)||$10 billion|
|Coca-Cola (NYSE:KO)||$9 billion|
|Philip Morris Int'l (NYSE:PM)||$9 billion|
That's 20 companies, and nearly 20% of total economic profits.
And that doesn't even include names like AT&T (NYSE:T) and Verizon (VZ), who just posted net income of $18 billion and $11 billion, respectively. Nor does it reflect significant bottom-line growth last year from Pfizer or Microsoft. Should we run this study again next year, there's a chance this list could be even more concentrated.
According to the Census Bureau, there are something like 27 million different firms in this country. And there's what, 5,000 publicly traded companies on the major exchanges and several thousand more in various OTC markets?
Unfortunately, data on total global corporate profits is a little bit more tricky to find. The point, though is that these bellwether companies and their foreign counterparts -- monsters like Volkswagen (OTCPK:VLKAY), Toyota (NYSE:TM), Gazprom (OTCQX:GZPFY), BP (NYSE:BP), PetroChina (OTCPK:PCCYF), and a bunch of Chinese banks, for example -- make up a significant share of total global corporate profits.
What does this degree of concentration at the top mean for investors and for the economy?
It's a good question.
Because I know you're curious, here's how those 20 have performed (equal weighted). Portfolio 1 is our 20 companies, Portfolio 2 is the S&P.
Which is about what you'd expect. It correlates very closely, outperforming slightly in the challenging periods like 2011 and lagging a bit during the rocket ride of 2013. If you extend this study further back, you'll also see that these quality names outperformed during the bear market, just as you might expect quality should.
But the bottom line is that if you have a portfolio that contains these twenty names -- and that's probably most of you -- you basically own the U.S. economy. This portfolio on its own is unquestionably sufficiently diversified, and it could even be a superior portfolio should the market flatten out or drop.
Which now begs the question...
What about valuation?
The average trailing P/E for those twenty companies is 15.9.
For the S&P, it's 16.
For the names at the very top, Exxon through Pfizer, it's even lower. The top half or so of these -- the biggest of the big -- trade at an average of around 13x earnings.
None of those numbers would represent any sort of valuation extreme. To say these companies are expensive right now, and, by extension, that the market is due for a meaningful correction, you'd need to also say that the earnings underpinning these names are at an unsustainable extreme. You'd have to say that the corporate profits as a percentage of GDP is too big, and has swung too far in favor of the corporation.
And as we just discussed, I'm not really comfortable saying any of that. The data just don't support it.
Relative to global GDP, I don't think that corporate profits have swung too far in one direction.
Now, U.S. corporations are currently reaping a larger share of the global economic pie than they have during most of the long boom. So it's possible that their piece may shrink slightly in relative terms in the years to come. But this isn't 1965 or 2007. We don't appear to be at an economic extreme, on the brink of an era where earnings are set for some heavy-duty mean reversion.
I mentioned at the top that on the individual profit margin level, we are indeed at an extreme.
But as you can see from this chart from the generally-excellent Cullen Roche, these things don't just revert on their own. It almost always takes a recession to bring margins back in line.
And this makes perfect sense, too. As earnings fall in an absolute sense, corporations respond to that by enacting measures that soften the blow. Margins tighten up during and in the wake of recessions.
I suppose this is all just another way of saying stop worrying about a contraction in margins and worry instead about recession. Worrying about the former is sort of pointless given the current environment, and worrying about the latter covers the former by definition.
The market will fall and margins will contract when the economy slows down. That's really it. I don't think we need to make it any more complicated than that. Market bulls and valuation bears are worrying about the same exact thing. Yet this doesn't stop them from talking past each other as they present their investment cases.
I realize that's a somewhat subtle point, and arguably not all that useful in a practical sense. But ultimately, we're all focused on the same thing.
Get Your Strategy Right
One thing you and I have in common is that we both want to know when the party is going to end.
The other thing we have in common is that neither of us has any clue.
It ends with recession, of course, but our ability to forecast those are somewhat limited. They're obviously imperfect, but this could perhaps be an era where we ought to be paying a bit more attention than normal to our more trusted leading economic indicators.
When it comes to designing a good investment strategy, we do need to be mindful of the potential ramifications of this setup. Given the current extremes in individual margins, the next recession could have significantly more nasty effect in the market than we might otherwise expect. Earnings may drop more than we might otherwise guess if we know the magnitude of the recession.
I think this is the right way to express concern about the profit margin situation -- not that they pose an independent risk of reversion on their own, but what additional downside volatility it could represent when the next slow cycle arrives.
I'll stop short of saying that a mild recession could generate 2008-style results. But when that next economic contraction does arrive, I don't think consensus will be nearly negative enough about what the ultimate market impact will be.
There are ways to guard against all that, of course. If individual names are your game, these 20 companies are an interesting place to start.
While it's basically impossible to argue that the mega-caps are any worse than "fairly priced" right now, some of the names from the next tier are indeed oddly expensive. Johnson & Johnson, Procter & Gamble, GE, Google, and Coke all trade north of 20x earnings. That's not only expensive in an absolute sense, it's also expensive for these companies relative to their own histories.
In a strategic context, I would not expect these types of companies to do what you think they might during a bear market. We think of JNJ, GE, KO, and PG as defensive names, but given the current margin and valuation situation, they're nowhere close to defensive. Their businesses may be great, but if you're thinking these will act as places that will do a better job preserving capital, you might wind up disappointed.
A lot of people laughed at me.
But basically every single one of those names -- high quality, rich valuation, and sporting super margins right now -- have underperformed the market since then. Nike (NYSE:NKE) and McDonald's (MCD) have been real dogs. What might have happened if we were on the brink of recession right now?
I'm far less concerned about the margin situation right now in a general sense than I am in how it may affect specific names.
The good news is that these 20 companies won't go bust in the next recession. They may suffer more than the market and we may be disgusted by them, but they will still be outstanding long-term destinations in which to grow capital. They're the types of companies that are good to have in your portfolio through thick and thin, especially if you've got a long-time horizon.
Given the state of profit margins right now and the valuations on some of these names, the next pullback will be one where, unlike the last, you probably won't want to own the whole bucket.
You'll want to pick and choose.
Disclosure: I am long AAPL, XOM, INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.