By David Berman
The bullish belief among Wall Street analysts is that super-high U.S. profit margins are here to stay as the economic recovery kicks into high gear. But that doesn’t faze James Montier, the asset allocation guru at global investment firm GMO LLC.
Wall Street bullishness, he said in his recent note to clients, “gives us some comfort because the Wall Street consensus has a pretty good record of being completely and utterly wrong.”
That’s right, count Mr. Montier among the dwindling ranks of skeptics as major stock market indexes hit multi-year highs amid rising confidence on employment, housing and economic activity.
He doesn’t attempt to skewer such optimism on the economy. Instead, he argues that profit margins are bound to revert to more normal levels as the government reins in spending – and when margins fall, the stock market could look pricey.
Right now, the S&P 500 trades at about 15-times trailing earnings, which is in line with the historical average and provides the oft-heard refrain that stocks are still reasonably priced, despite doubling in price over the past three years.
However, using a 10-year moving average of earnings – which smoothes out the economic cycle – the index trades at about 24-times earnings. That’s a big gap, and Mr. Montier believes it highlights the divergence of profits from their long-term normal levels.
All it would take to bring this divergence back down – and force corporate profitability to struggle – is a significant drop in government spending (code name: austerity). After all, free-flowing government dollars have been boosting corporate profitability in recent years, so a reverse should have the opposite effect.
While significant spending cuts might not happen in an election year, they seem like a sure thing over subsequent years as the government attempts to bring down its deficit. Mr. Montier fails to see any other areas of the economy ready to pick up the slack.
“Corporate investment may increase slightly from today’s levels, but to really surge would require a strong economic recovery and the return of Keynes’s infamous animal spirits,” he said. “Leading economic indicators don’t suggest that this is currently on the horizon. Likewise, the housing starts data suggests that housing investment is likely to be essentially flat.”
Of course, the U.S. government isn’t the only own struggling with its spending levels, which is why Mr. Montier sees trouble elsewhere too – particularly in the euro zone, the U.K. and Japan.
“It seems unlikely that ‘this time is different’ when it comes to mean reversion in margins,” he said. “What goes up must come down.”