Hussman on Record High Profit Margins vs. Stock Valuations

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John Hussman, president of the Hussman Investment Trust (Hussman Funds), has an interesting note out this week titled "A False Sense of Security", which discusses market valuation methods, corporate profit margins, secular/cyclical markets, the Fed, and the current market climate. I think he's on to something with corporate profit margins. He mentioned that the stock market, which is valued using a multiple on forward earnings estimates (EPS), could get spooked if record high profit margins start to revert back to historical norms. He showed a chart of Corporate Profits (after tax)/GDP, which is currently at a record high above 10% (since 1947).

"There are a lot of factors and quiet math that affect the P/E multiple that can be appropriately applied to earnings. Slapping an arbitrary multiple onto elevated earnings reflecting extraordinarily inflated profit margins ignores all of it.

The upshot is that if investors are willing to believe (without the use of off-label hallucinogens) that current profit margins are the new normal, and will be sustained indefinitely, then Wall Street's valuations based on current and forward earnings estimates can be taken at face value. This assumption of a permanently high plateau in profit margins is quietly embedded into every discussion of "forward earnings" here.

So, if there is an unforeseen crash in profit margins, analysts would rush to slash EPS estimates, the market multiple would probably contract during this chaos, and the S&P would get repriced to the downside. But, there is a chance we see perma-high profit margins if robots take over the labor force. IBM's Watson computer just got hired by Citigroup. It is interesting that corporate profit margins and the long-term unemployed (27 weeks+) are both hitting record highs. Hussman also discussed how market valuations change during secular and cyclical, bull and bear markets. He thinks we are still in a secular bear market.

"If you examine market history as far back as the late-1800's, you'll find that market valuations have moved in broad advancing and declining phases, with each phase lasting about 17-18 years in duration (that still should be treated only as a tendency, and there's no reason I know for treating it as a magic number). As an example, stocks moved from extremely low valuations in 1947 to quite rich valuations by 1965, producing a long "secular" bull market where each successive cyclical bull market topped out at higher and higher valuation multiples. In contrast, from 1965 to 1982, valuation multiples went through a long contraction, where each successive cyclical bear market bottomed out at lower and lower valuation multiples."


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