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 a year or two ago and I've been exploring the concept and its ramifications in our newsletter for a while now. I am fascinated and obsessed by this idea 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.
Anyway, the other day I ran through a brief mathematical exercise to figure out where the S&P might trade at if corporate earnings did contract a bit. The answer surprised even me.
In essence, this is all just another way of restating the case for using normalized PE ratios like the Shiller PE to more accurately gauge market valuation. Some people enjoy that. Some don't. For what it's worth, I like doing it. Besides, if you're using only one method to value the market, you haven't been at this for very long.
There's no disputing the data. On this we all can agree. Corporate earnings are indeed gigantic. As a percentage of GDP, they're as big as they've ever been.
While the data can't be debated, the way that people interpret and respond to that data is subject to all sorts of variation. Guys like Grantham believe it matters. Ken Fisher shrugs it off.
Every so often I hear somebody get up on CNBC or Bloomberg Radio and say that today is just like 1983 and that we're at the dawn of the next great secular bull market and investors should be buying stocks like Apple with both hands! I scratch my head and wonder what it is they see that I don't. Without the ability for corporate profits to swell - higher earnings support higher multiples - and room for greater investor risk appetite - hungrier investors drive higher multiples - a market loses two of the biggest forces that power a secular bull trend. They might even be the only two forces that matter: earnings growth and multiple expansion.
Sure, a super bull market could still be born tomorrow. But those are fairly significant hills to overcome, nevermind that we're also missing that wonderful, warm, multi-decade tailwind of systemic leveraging, credit that expanded and expanded at every level from the early 80's until 2005. But that's a story and analysis for another time.
So let me ask you an honest 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? 15% of GDP? 20? All of GDP?! Maybe they'll just flatten out up here and stay in a range? Or maybe you're a disciple of guys like Grantham and Shiller and you believe the probabilities suggest earnings will revert towards a more normal historical 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.
The Adventure Begins
That got me thinking about two things that we do know. We know that earnings are flattening out. They might grow and balloon to 15% of GDP next year, but it sure ain't happening this year. We've either reached a local peak or we're resting at a plateau on our ascent up the mountain of madness.
The second, less appreciated, thing we know is where they come from. Most top-down earnings analysts don't take this extra little step to decompose corporate profits a little further.
So I made a simple list of the 10 most profitable corporations. I used the most current data I could find and this list isn't exact either. Individual earnings are always shifting, loose shards of talus upon which we try to erect our base camp.
|Company||Profits (after tax)|
|Apple (AAPL)||$47 billion|
|Exxon Mobil (XOM)||$41 billion|
|Chevron (CVX)||$27 billion|
|Microsoft (MSFT)||$23 billion|
|Ford (F)||$20 billion|
|JPM (JPM)||$19 billion|
|AIG (AIG)||$18 billion|
|Wells Fargo (WFC)||$16 billion|
|IBM (IBM)||$16 billion|
|WMT (WMT)||$16 billion|
Per FRED, on 6/30/12, total U.S. corporate profits after tax was $1,665 billion.
So that means that those ten companies represent a staggering 13.6% 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)|
|General Electric (GE)||$14 billion|
|Intel (INTC)||$12 billion|
|ConocoPhillips (COP)||$12 billion|
|Proctor & Gamble (PG)||$12 billion|
|Citigroup (C)||$11 billion|
|Berkshire Hathaway (BRK.A)||$10 billion|
|Pfizer (PFE)||$10 billion|
|Google (GOOG)||$10 billion|
|Johnson & Johnson (JNJ)||$10 billion|
|General Motors (GM)||$9 billion|
That's 20 companies, 20% of the economy.
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?
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):
Which is about what you'd expect. It correlates very closely, outperforming slightly on the way down and lagging a bit on the way up.
On a 5yr risk-adjusted basis, this portfolio seems to be a little preferable than the S&P.
In case you were wondering how big a geek I am, my fantasy football team is named "The Efficient Frontier." So I really like charts like this one.
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. I would suggest that it's sufficiently diversified.
Which now brings us to...
The Quick 'n Dirty Strategy Section
If you want to make a broad, long-term bet on the U.S. economy, a slightly more concentrated portfolio like this might be a better way to do it. If you're a mutual fund manager with a good marketing department, you should have no trouble getting away with a portfolio like this (and I shudder to think how many of them actually are right now). Some years you'll beat your benchmark and some years you won't and the long-term data will be sufficiently muddy that you'll be able to justify keeping your job. So long as you're good at schmoozing with the board.
There are other, more exotic trades to be made from this information. Maybe you want to short this basket over the S&P, especially if you do it after a market correction and want to isolate some positive performance via rebound but don't want to take the full risk of being nakedly long. That's an idea.
Or since all of Wall Street already owns these companies, maybe something special happens to them in certain unique environments? Maybe they're the first (or last) place investors go when they want to raise liquidity. This is a topic for an entirely separate research piece.
Finally, there's an intriguing politico-economic component as well. In case you're ever wondering who shapes policy in this country, these are the companies that shape policy. These companies make the laws, not the American people, and they make laws that serve them, not necessarily the American people. $300 billion can buy you all the lobbyists you could ever want. We don't call the shots, they do, and they influence our votes in myriad clever ways. But what if that changes? What if the political winds shift? Forget all this silly chatter about socialism. The real fear, for the market at least, should be a new, more intelligently evolved wave of populism.
There are many different directions you can go with this data. If nothing else, the exercise is simply an interesting informational arrow to store in your quiver for future use.
The View From the Summit
To bring the discussion full circle, these 20 companies might be a good place to start if you are looking for a bottom-up signal for when/if corporate profits start to contract. These are the names you should listen to. They'll probably lead the way. Especially since we now know just how much of total corporate profits they contribute. When Apple and Exxon and JP Morgan start talking about margin pressure, I'm getting nervous. And if the market hasn't corrected yet, that's the day I start fully hedging my portfolio. I worry about the negative feedback loops that spiral out of a company like Apple starting to struggle with earnings margins.
Look: We all know why the market is up at these levels today in spite of fiscal and economic risks that to most seem ridiculously obvious. It's up here because, on the surface, it seems sensibly priced. But more importantly, there is zero competition. Not with ridiculously low interest rates and the bootheel of Q-Infinity pressed firmly on the neck of the yield curve.
Most investors simply have no choice. Stocks are their only option. And so they buy.
Somewhere, Ben Bernanke is grinning. But it's a nervous grin. He knows the game that he's playing, and he, like the rest of us, really only has one choice.
Disclosure: I am long XOM.
Additional disclosure: For additional disclosure see cognitiveconcord.com/legal-notice/