This commentary originally appeared on Real Money Pro at 8:36 a.m. ET on March 21.
NEW YORK (
Real Money Pro
-- While the markets continue their resilient and consistent advance, some serious concerns (on the technical, economic, political and geopolitical fronts) are being thrust aside.
Sir Larry Kudlow
that "profits are the mother's milk of stocks, and for that matter, business and the entire economy" -- and I agree. But, in a series of recent columns, I have suggested that corporate profit margins, the most mean-regressing economic series extant, are likely to contract -- and with it,
earnings will likely fall short and disappoint relative to consensus forecasts.
GMO's James Montier has echoed and materially expanded my analysis on profitability in
a March commentary piece
that is a must-read by all investors.
Corporate margins are the highest in history, at a time when the economy is on stall speed and does not yet show signs of a self-sustaining recovery. The condition, as a former
chairman might have called it, is the "profit margin conundrum."
Graham & Dodd P/E Far in Excess of Current P/E
"Whilst we at GMO fret over evidence of the strained nature of profit margins, the ever bullish Wall Street analysts expect profit margins to continue to rise! (Witness Exhibit 4). In our search for evidence of a structural break, this simple-minded extrapolation gives us some comfort because the Wall Street consensus has a pretty good record of being completely and utterly wrong." -- GMO's James Montier
While price-to-earnings multiples at slightly under 14x are inexpensive by historic standards, they could be very expensive if the currently high profit margins mean regress.
The divergence in current and reported P/Es to a smoothed-out version (Graham and Dodd) of the 10-year moving average in profits ("more normal" profit margins) is conspicuous, and takes the current 14x price earnings multiple to an expensive 24x.
This simple comparison underscores how far earnings (and profit margins) are from "trend line" returns and demonstrates the risk if profit margins mean revert.
The Prognosis for Profits Is Not a Pretty Picture
"To us, the macro profits equation is a simple but powerful tool for understanding the drivers of profits, and helps us assess their sustainability. It is a useful organizing framework for thinking about the possibility of a structural break in profit margins. When we look at the drivers of today's high profit margins, we find fiscal deficits behind the high profit margins of many countries. There is nothing "wrong" with this per se, but it does suggest that moves toward fiscal retrenchment will bring margins back toward more normal levels. It seems unlikely that "this time is different" when it comes to mean reversion in margins: what goes up must come down." -- GMO's James Montier
To understand the drivers of profits (and more importantly, frame a forward-looking outlook), Montier provides a framework in the economist Kalecki's macro drivers of profit.
Here is Kalecki's profits equation:
Profits = Investment - Household Savings - Government Savings - Foreign Savings + Dividends
I will put aside Montier's explanation and analysis, as most might be put to sleep (especially the non-fundamentally inclined momentum-based investors and traders who have the patience of a flea). But when Montier deconstructs the above equation, he concludes that "net investment has generally been the biggest driver of corporate profitability over time. However, the standout engine of corporate profits of late has been the fiscal deficit."
Suffice to say, Montier sees the drivers of Kalecki's equation (and that of corporate profits and margins) as vulnerable. Corporate investment may increase slightly, but a strong recovery is needed - and recent economic data (e.g., leading indicators and housing) don't encourage him.
While the federal deficit may stay elevated in an election year, Montier thinks it is "unthinkable" that the deficit will be allowed to stay at current levels in the years ahead.
As a consequence, unless households begin to re-leverage or the current account improves dramatically and assuming some sort of deficit reduction plan is embraced, corporate profits "are likely to struggle."
Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.