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Kass: Flawed Case for a Bull Market

Joe Kernen: So tell me, Jim, what are your thoughts on the U.S. stock market?
Strategist: Stocks are cheap, trading at only 15x my 2014 estimate of $120 a share for the S&P 500. That's in line with the historic averages. But stocks are cheap with the 10-year U.S. note yielding under 3% compared to around 6% over the last five or six decades.

-- An imaginary CNBC "Squawk Box" interview between Joe Kernen and a strategist

The above conversation, though not real, has grown more popular and repetitive, embodying the market narrative these days with any of a number of market strategists. The simple market logic template is being trumpeted ad nauseam throughout the day in the business media not only on CNBC but also on Fox Business, Bloomberg, financial blogs and other media venues.

This morning's opening missive attempts to address and possibly refute the logic of this accepted (and simple) valuation argument that embraces the essence of current bull market thinking.

Misconstrued Valuation Calculation

The cornerstone of the bull market case is that valuations are reasonable and not excessive by historical standards. It is further argued by the bulls that given the low rate of inflation (and inflationary expectations) and very low interest rates, the current level of valuation is justified and even inexpensive.

The conventional method of calculating P/E multiples based on stated or raw earnings is, arguably, a fundamentally flawed approach that assumes currently elevated profit margins and profits are sustainable. Indeed, measures that normalize margins have almost always correlated better to U.S. stock market performance over history.

It is only the cyclical (and elevated) position of profit margins that prevents recognition that equities are richly valued.

I would argue that to utilize earnings that reflect profit margin that are more than 70% above the norm (over a documented span of over 65 years) is an aggressive assumption and fails to adjust for the unique and changing conditions that contributed to the sharp improvement in margins since 2009 -- all of which are deteriorating and likely putting renewed pressure on margins.

Investors should consider evaluating current valuations from the context of normalized earnings not based on today's elevated (raw) profits and profit margins.

How Will the Variables That Produced High Profit Margins Trend Going Forward?

There are three important factors that have contributed to unusually high corporate profit margins -- all of which have begun to reverse.

  • Corporate interest expenses have experienced a marked reduction. Generational low interest rates have boosted margins dramatically. Over the weekend, Barron's' Randy Forsythe quotes MacroMavens' Stephanie Pomboy, who submits that lower rates have contributed more than $300 billion to aggregate corporate profits since 1997. In all likelihood, interest rates will rise over the next several years, perhaps materially, driving corporate interest expenses higher.
  • Effective corporate tax rates have undergone a steady decline. Through offshore tax havens and other methods, corporations have consistently lowered their taxes. (Note: I fully discussed this trend earlier this year in "Addressing the Fiscal Cliff."). The reduction in corporate interest expenses (above) combined with lower effective tax rates have contributed to more than one third of the improvement in corporate profit margins. In all likelihood, tax rates will climb over the next several years, as our leaders in Washington, D.C., address the ballooning deficit.
  • Corporations have reduced their fixed costs by cutting overhead, shedding jobs and making temporary workers a more permanent part of the workforce. Year-over-year productivity growth in third quarter 2013 was zero compared to +0.2% in second quarter 2013 and as contrasted to significant gains over the past five years. Productivity growth has slowed steadily over the past year, as year-over-year unit labor costs are now +1.9%. Corporations have cut to the bone, and productivity gains are in the process of reversing now.

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