It has been awhile since we've discussed fundamentals, but it is definitely something subscribers of our newsletter can expected quite frequently. In today's chart of the day, we can safety assume that corporate profits tend track the overall growth of the economy. While not always true, generally this tends to be the case majority of the time (link here). After a four year expansion, in recent months my view has been that profitably has most likely reached its peak. There are a few observations we could make by looking at chart below:
- Corporate profits as a % of GDP are extremely high and rolling over
- Historically, profit margins are very cyclical and volatile in nature
- During secular bear markets, mean reversion impacts equity prices
- Best time to invest into equities is when profits are at depressed levels
Irrespective of weather one sees valuations as attractive or fundamentals as improving (personally I think neither is true), one should always be cautious when profitably reaches extreme levels like we can see today. The fact of the matter is that corporate profits as a percentage of GDP have rarely reached dizzying heights like at present and the most likely scenario is mean reversion in coming quarters. Therefore, I think it is prudent that investors ask themselves weather or not they want to be positioned on the long side right here.
Chart 1: Corporate profit margins could soon mean revert
Source: Short Side of Long
Historically, the best time to invest into equities has been during disappointment in corporate profits. Certain readers are most likely asking why would corporate profit margins mean revert? Why couldn't they stay elevated?
Well basically, the recent expansion has been built mostly on labour cost cutting and that is why margins have managed to approach record highs despite anaemic growth in the last few years. With Federal Reserve and US government closely linked towards a goal of further employment, one has to consider the following:
As US debt problems come to the forefront of global attention (just like Europe), further public support will soon start to fade and austerity will take its place. With wage growth at very low levels, households will not be able to maintain spending for a prolonged period of time (ECRI already thinks we are in a recession).
On the other hand, if CEOs suddenly (read: magically) turn optimistic, they might consider boasting their payrolls. But ask yourself, at what cost? Obviously, the answer would be at the cost of decreasing their margins.
And if CEOs opt for further cost cutting instead? With subpar growth (last GDP quarter was flat if you believe BLS and most likely contracted if you do not), this could definitely increase risks and dip us into a recession.
Therefore, you are damned if you do and damned if you don't. In my opinion, we are about to witiness a mean reversion in corporate profitability regardless of outcome, as we have most likely has reached its limits for the cycle. Now comes the painful part, which is usually jam-packed with earning disappointments and investor losses (especially during equity secular bear markets).
What I Am Watching