Which brings us back to your initial point: the HFT hatred is really overdone, for what is really a minor distraction.

Similarly, when businesses run deficits (borrow to invest), that creates pseudo-money (corporate bonds and loans outstanding) and again, the rich savers must end up owning that pseudo-money and they do so mostly via increased corporate earnings. (If company A borrows to buy capital products from company B, that tends to boost company B’s earnings, etc.) Right now corporate borrowing is moderate.

Conversely, savings by households tends to depress profits, as does a trade deficit. (A trade deficit boosts earnings in another country). Right now, household savings is moderate and the trade deficit is well down from its highs.

Conversely, when everyone is trying to save, profits take the first hit. (If ex ante savings exceeds planned investment, then there must be corporate dis-savings to offset household savings, so as to allow ex post savings to equal investment).

Relative abundance/scarcity of capital and labor only comes into play when there is no possibility for labor to save. That might be true in places like Bangladesh, where people have to spend every penny they make on food, but it is certainly not true in the United States. If labor can save, it will do so in the face of high returns on capital. These household savings will (a) crush short-term profits on capital, as explained in the previous paragraph; (b) produce a long-term surplus of capital, thus eliminating the oversupply of capital relative to labor. Of course, effect (a), by crushing profits, would remove the incentive for higher savings, and thus postpone effect (b). The final result is that returns on capital are unaffected by capital-labor relative supplies.

I know you despise Keynes, but it was Keynes who first analyzed profits correctly. Read up on the Kalecki equation, since Kalecki clarified Keynes’s formulation. There is a paper on gmo.com by James Montier “What goes up must come down” about this subject.

The current minimum is the speed that the computers will operate. That is apparently too little. Some amount of time that is longer than a human can execute at would be too much. One second is an interesting compromise.

The issue still might be market-making and HFT’s role as a market making entity. Resolving that could have the add on effect of solving other issues.

If enough companies practice this then down years may be worse and up years better, exaggerating the normal cycles. Do you have any insight on this?

Thanks for all your effort on this site and for being a great educational resource.

Furthermore Jeff Miller’s question displays some ignorance of why the Shiller P/E works the way it does. When people discuss profit margins they ae not discussing a separate issue, but one integral to understanding the CAPE. They are merely saying that the reason CAPE shows an overvalued market compared to simple trailing or forward P/E is because profit margins are high. They are saying that current P/E ratios are misleading about whether the market is cheap or not.

Second, they are pointing out that even if profit margins do not revert, but stay where they are (which is at record levels) then forward earnings estimates are too high and will need to come down. Growth will slow to about GDP growth once margins stabilize.

Which leads to a further point about current P/E’s. They should be low. As Jeremy Grantham loves to point out, markets get extremely undervalued and extremely overvalued because investors do a form of double counting. When profit margins are low (and thus likely to mean revert upward) we give them a low multiple as well. When profit margins are high (and thus likely to mean revert downward) we give them a high multiple as well. This is the exact opposite of what an efficient market should do. This is the lowest multiple investors have given peak margins since the late 1990′s, but given that margins are at an all time high the P/E should likely be at an all time low relative to a non recessionary state of affairs. It won’t be, because investors just do not act that way, but that they are giving a seemingly low P/E to present earnings is the only reason we are not in another extreme bubble like 2000, and instead are only at an ordinary peak in valuations. Presently we are most similar to the mid 1960′s in terms of overall market value.

Profit margins have repeatedly peaked and crashed violently in recent years. The implicit argument behind margins staying high is that the crashes have been external events that have interrupted a happy new era of high and rising profit margins and over longer terms (the only terms that matter when discussing asset class level valuation such as Shiller, Q ratio, etc., ) we should expect black swans such as 2000 and 2008 to not repeat.

There is another way to look at it of course, and I think it is at least to a large extent correct. The artificially high profit margins are a product (and cause) of the volatility, so we will get either more economic stability and lower margins or we will get continued economic volatility and even more volatile profit margins. In either case CAPE will tell an accurate story.

Why might this relationship exist? For example I would argue that prior to the 2008 a profit margin collapse was a big part of the case for why the stock market would crash. It sure was for me. They were built largely on leverage, especially for financials, and slow wage growth after the previous recession/bear market which was dominated by overcapacity in the TMT bubble. The margins were inherently a product in both cases of a bubble. In addition margins had increased dramatically in energy driven by unsustainable bubble demand as well. Thus the margin collapse was both a cause and effect of the crisis. When margins collapsed companies were crushed and they started laying off workers which reinforced the negative economic downward spiral.

We see similar things now, with margins held aloft by government largesse and a slow elimination of overcapacity and excess labor along woth a likely bubble in China. Should China rollover, government largesse decline and/or overcapacity becomes less of an issue or for any reason we have a recession then the margin collapse will once again be the flipside to the margin peaks. What fat would companies be able to cut to protect them in a falling sales environment?

To sum up, the CAPE incorporates the high margin argument, the talk about margins is just an exploration of CAPE and its implications, not another factor being shoehorned into the discussion.