Kass: Flawed Case for a Bull Market
Let's take a look at the chart below, which depicts how elevated after-tax corporate profit margins are relative to GDP and how rapid the improvement has been in the last four to five years.
Indeed, the series today stands at the highest level in almost 70 years.
The chart represents the greatest risk to the valuation case for U.S. stocks, as, over history, profit margins are among the most mean-reverting economic series extant.Raw P/E and raw price-to-forward-operating-earnings look reasonable only because profit margins are about 70% above their long-term norms.
Other Valuation Metrics Yield Extreme ReadingsEvery ounce of my cynicism and analysis is supported by historical precedent. With the assistance of Dr. John Hussman, the elements of my overvaluation case are underscored by the following seven items that look beyond raw earnings: 1. The median price-to-revenue ratio of the S&P 500 is now at an historic high, eclipsing even the 2000 level. 2. The Shiller P/E is above 25, exceeding all observations prior to the late-1990s' bubble except for three weeks in 1929. 3. Market cap-to-GDP is already past its 2007 peak and is approaching the 2000 extreme. 4. The implied profit margin in the Shiller P/E (denominator of Shiller P/E divided by S&P 500 revenue) is 18% above the historical norm. On normal profit margins, the Shiller P/E would already be 30. 5. If one examines the data, these raw valuation measures typically have a fraction of the relationship to subsequent S&P 500 total returns as measures that adjust for the cyclicality of profit margins (or are unaffected by those variations), such as Shiller P/E, price-to-revenue, market cap-to-GDP and even price-to-cyclically-adjusted-forward-operating-earnings. 6. Because the deficit of one sector must emerge as the surplus of another, one can show that corporate profits (as a share of GDP) move inversely to the sum of government and private savings, particularly with a four- to six-quarter lag. The record profit margins of recent years are the mirror-image of record deficits in combined government and household savings, which began to normalize about a few quarters ago. The impact on profit margins is almost entirely ahead of us. 7. The impact of 10-year Treasury yields (duration 8.8 years) on an equity market with a 50-year duration (duration in equities mathematically works out to be close to the price-to-dividend ratio) is far smaller than one would assume. Ten-year bonds are too short to impact the discount rate applied to the long tail of cash flows that equities represent. In fact, prior to 1970, and since the late-1990s, bond yields and stock yields have had a negative correlation. The positive correlation between bond yields and equity yields is entirely a reflection of the strong inflation-disinflation cycle from 1970 to about 1998.
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