Dr. Jeff Miller wrote an interesting question the other day:
“Why does a Shiller disciple care about profit margins?“
Now, I am not a disciple of Dr. Shiller, I disagree with him on many issues, Trills for an example.? When Shiller talks, odds are 50-50 that I agree, which makes him interesting to me, unlike Bernanke and Krugman who I almost always disagree with, and James Grant and Caroline Baum, who I almost always agree with.? Someone who agrees with me and disagrees with me equally is interesting, because he makes me think harder.
And with his cyclically-adjusted price-earnings [CAPE] ratio, I was a reluctant partial convert.? Consider this piece.
There are a couple ways to answer the question:
- Most stocks are cheap on a forward P/E basis, less so on a trailing P/E basis, and still less so on a P/B or P/S basis.? The difference between P/E and P/S is profit margin — E/S.
- Consider the critiques from Dr. John Hussman, who awaits the reset that will come if/when profit margins get competed down.
- My answer: we should care about it a little, for the above reasons.? But labor is no longer scarce, which leads to higher profit margins for a time while wages are depressed.
My view is that profit margins will not revert to mean for many years, until the increase in capitalist labor is absorbed.? Until then economic results will be poor those that labor on the low end — you have got a lot of new competition.
A reason to consider the validity of the CAPE is twofold: it has a huge similarity to Tobin’s Q-ratio, which compares market capitalization to replacement cost.? It also has a similarity to Michael Alexander?s Price-to-Resources ratio, out of which the book makes a lot (link here for an example).? It?s a Price-to-Adjusted Book value ratio as I see it.
The CAPE has value as a proxy.? It mirrors overall market value pretty well, like other fundamental ratios.
But I don’t agree, at least in part because profit margins should remain high, until readily obtainable labor is less scarce.? Getting there could be a long time.? Profit margins could remain high for a long time as a result, leaving? markets in a limbo zone, where it treads water as underlying value builds.
So profit margins should remain high for now.? Once labor is scarce globally,? and companies must pay more to get more or better quality labor, then will profit margins come under stress.
High profit margins are due to two things: revenues and costs.
I think you make a fair point in that with higher unemployment there isn’t much pressure on wages and therefore companies can keep costs low (perhaps for a few years as you suggest.) But what about the flip side?
With high unemployment levels, who is going to buy the high priced goods? Top that off, household debt levels (in the US and some other places worldwide) are still high. Many folks have mortgages that they can barely afford, with little to negative equity, high credit card debt, high student loan debt, etc. So households won’t be able to borrow to continue their previous spending habits.
Why won’t prices (hence revenues) come down thereby causing profit margins to mean revert? I guess I’m inclined to think that something has to give; this isn’t sustainable.
A couple months back I actually blogged about The Forthcoming Profit Recession (http://bubblesandbusts.blogspot.com/2012/03/forthcoming-profit-recession.html).
The basic theory was using Kalecki’s profit equation to show that government deficits are actually driving the currently high profit margins. If the budget deficit shrinks in 2013 then profit margins are likely to follow.
Good, I didn’t want to elaborate on my claim that government largesse has a lot to do with high margins. I had gone on long enough. I’ll just say, “what he said!”
I agree that profit margins might stay high for the reasons you state, though there have been periods when labor was not scarce and profit margins still were much lower than now. Competition and other factors can still drive down margins.
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.
Regarding CAPE, I’ve been wondering recently if profit cycles may actually be more exaggerated given current accounting rules. In Graham’s Intelligent Investor I believe there is an updated section about companies writing off future expenses in bad years (eg. FCX lost over $14/share in ’08).
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.
I do think the use of “operating” earnings distorts P/E’s at the asset class level. CAPE uses as reported earnings. Present P/E levels look much worse using reported earnings.
Thanks for the reply Lance. I should have specified “operating” earnings. Also, I like Grantham’s point about double counting, although as you point out it won’t do much for short-term investing. As long as profit margins mean revert over time, there will be far better entry points in the future.
Profit margins are high because the government is running a huge deficit. Think about it. When the government runs a deficit, it creates money. That money ultimately has to be owned by someone, and that someone is the rich savers, since the poor don’t save very much. And rich savers tend to get most of the their income from corporate earnings.
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.