Great Profit Expectations Can't Be Met

This column by Doug Kass was originally published on Feb. 13 at 8:56 a.m. EST on Street Insight. It's being republished as a bonus for TheStreet.com and RealMoney.com readers. For more information about subscribing to Street Insight, please click here.

"Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly."

-- Jeremy Grantham

Yesterday we argued that a key tenet to the rosy view of the markets -- the government's release of relatively low inflation rates -- is bunk, and that the rate of inflation has been systematically understated.

By contrast, I wrote that I prefer to look at the Cleveland Federal Reserve Bank's weighted median CPI to get a better gauge on the real level of inflation.

Today we argue that the generally accepted observation that forward P/E multiples are relatively low -- another essential argument underlying the bullish market view -- is also likely to be proven incorrect.

Corporate profits are booming. In fact, U.S. corporate profits in 2006 rose to their highest as a portion of GDP in over 75 years.

The chart below, prepared by ContrarianEdge.com's Vitaliy Katsenelson, graphically depicts how high current corporate profit margins are above trend line.

In many ways, Katsenelson's analysis reminds me of the chart of housing affordability (home prices divided by household incomes) which, when stretched into a two-sigma event in late 2004-early 2005, served as a catalyst for a sharp downturn in the housing markets in 2005-07. It is my view that expectations of business profit margins and corporate profits over the next several years might outrun both the economy's potential to deliver, and most traders' generally bullish expectations.

Demand and productivity, price and cost levels, risk perception, credit volume and credit difficulties are all incorporated into forecasts of future profitability, and the relationships among these variables can be viewed as constituting an enduring core of the business cycle. External shocks and policy effects are more transitory and at the periphery, but they have to be considered in forecasts.

Click here for larger image.

Source: ContrarianEdge.com