High Current Profit Margins Suggest Poor Earnings Growth Ahead

| November 15, 2010

In his latest weekly commentary, fund manager John Hussman reviewed the correlation between US corporate profit margins and subsequent 5-year earnings growth, noting that record high profit margins are usually followed by very poor earnings performance.

I’ve reviewed the valuation conditions of the stock market extensively in recent months, emphasizing that stocks are not a claim on a single year’s earnings, but rather on a whole stream of future cash flows that will be delivered to investors over time. At present, investors and analysts who focus on simple price/earnings multiples (rather than modeling the entire stream of cash flows) are placing themselves at tremendous risk, because simple P/E multiples are being distorted by unusually wide profit margins. Part of this can be traced to weak employment conditions, which have held down wages and salaries. But there is more to the story – the rebound in profit margins also reflects a heavy contribution from financials (which may be more indicative of accounting factors than sustainable earnings), as well as the tail-end of stimulus spending.

The chart below underscores the relationship between high current profit margins and poor subsequent earnings growth. The blue line shows U.S. corporate profits as a percentage of GDP (left scale), which is currently just over 8% and at the highest level since 2007. The red line depicts subsequent 5-year growth in profits, but on an inverted right scale (higher values are more negative). In effect, it should not be a surprise if present levels of corporate profits are followed by negative profit growth over the coming 5 years. Indeed, the 2009 burst of stimulus spending is most probably the only factor that has prevented profit growth from being negative over the most recent 5-year period.

Municipal bond investors are clearly re-evaluating the prospects for additional fiscal stimulus from the federal government. Indeed, many state and local governments (as well as health and disability service providers that benefited from stimulus dollars), are beginning to talk about “the cliff” – an abrupt reduction in revenues due to the loss of current stimulus funding which has been used to bridge existing budget shortfalls. My impression is that equity investors face a similar “cliff” which they may not have adequately recognized yet. The essential point is that stocks are much more richly valued than simplistic P/E multiples would suggest. Investors may pay a heavy price if they fail to adjust valuations for the level of profit margins. The only proper way to value stocks is in relation to measures of sustainable, long-run, full-cycle financial performance.

Category: Commentary, Market Update

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