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-
, 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.
That said, I can count a number of factors that could result in a contraction and mean reversion of corporate profits: rising interest rates, a tightening labor market, a host of cost pressures in materials and/or an end to the enormous productivity gains of the past five years. As well, in a world of heightened geopolitical risks, normalcy can quickly morph into abnormalcy -- and higher prices of "stuff," like oil, to levels never imagined.
Although the U.S. economic upswing of the last several years provides a vivid example of how profits, investment, and an exuberant stock market can reinforce each other, long business expansions, as seen in the chart, have been hard to sustain over time.
The most vivid example outside the U.S. was Japan in the 1980s, when an investment-driven and speculative boom gave way to protracted stagnation. In the U.S., after deterioration in the 1970s and early 1980s, U.S. business cycles moderated again, as in the first two post-World War II decades. But globally, recessions became more frequent and more severe in the second half of the postwar era.
History teaches us that "what goes up must come down."
Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd. Until 1996, he was senior portfolio manager at Omega Advisors, a $4 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."
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