Hussman: Beware Profit Margin Mean Reversion

by: Cullen Roche

John Hussman has a good note out this morning detailing his perspective on corporate profits and margins in particular. He cites the fact that margins are notoriously cyclical and mean reverting and that declining margins mean deterioration in profits. With margins are record wides we certainly shouldn’t expect corporate profits to remain as robust as they’ve been. He details his outlook:

The following chart may help to bridge that gulf. Essentially, analysts who view stocks as “cheap” here are invariably basing that conclusion on current and year-ahead forecasts for earnings. In contrast, analysts who view stocks as richly valued are typically those who view stocks as a claim not on this years’ or next years’ earnings, but instead are a claim on a long-term stream of deliverable cash flows. Simply put, there is presently a massive difference between short-horizon earnings measures and longer-term, normalized earnings measures.

What’s going on here is that profit margins have never been wider in history. But profit margins are also highly cyclical over time. The wide margins at present are partly the result of deficit spending amounting to more than 8% of GDP – where government transfer payments are still holding up nearly 20% of total consumer spending, and partly the result of foreign labor outsourcing (directly, and also indirectly through imported intermediate goods) which has held down wage and salary payouts. Indeed, the ratio of corporate profits to GDP is now close to 70% above its long-term norm.

Now, if you look at the red line (right scale, inverted), you’ll notice that unusually high profit shares are invariably correlated with unusually low growth in corporate profits over the following 5-year period. Thanks to continuing deficits and extraordinary monetary interventions, this effect has been largely postponed in recent years, allowing profits to expand to present extremes. We are not arguing that profit margins necessarily have to decline over the near-term, and our concerns don’t rest on the assumption that they will. It is sufficient to recognize that the bulk of the value of any stock is not in the early years of earnings, but in the long tail of future cash flows – especially if payouts are low. Stocks are essentially 50-year instruments here in terms of the cash flows that are relevant to their valuation. There are a lot of factors and quiet math that affect the P/E multiple that can be appropriately applied to earnings. Slapping an arbitrary multiple onto elevated earnings reflecting extraordinarily inflated profit margins ignores all of it.

(Click to enlarge)Click to enlarge

The upshot is that if investors are willing to believe (without the use of off-label hallucinogens) that current profit margins are the new normal, and will be sustained indefinitely, then Wall Street’s valuations based on current and forward earnings estimates can be taken at face value. This assumption of a permanently high plateau in profit margins is quietly embedded into every discussion of “forward earnings” here.

These are really good comments. I outlined my outlook the other day and I think these profit warnings will all be prescient – at some point. But timing is key here. We know what the main driver of profits has been during this cycle – the budget deficit. And we can time with some accuracy, where the deficit is going in the coming years. We know the government is set to spend roughly $1T this year so that’s a mild decline from the last few years. But the big risk is the 2013 outlook where the CBO is expecting a sharp decline to $550B. That would certainly ding corporate profits and drive margins back to the mean. The bottom line – the coast is clear for now, but there are storm clouds on the horizon and we might well be steering this ship directly into an oncoming storm….Stay tuned as we head into 2013.