Corporate profit margins are presently 70 percent above the historical mean going back to 1947, as I’ve discussed earlier (see, for example, Warren Buffett, Jeremy Grantham, and John Hussman on Profit, GDP and Competition). John Hussman attributes it to the record negative low in combined household and government savings:
The deficit of one sector must emerge as the surplus of another sector. Corporations benefit from deficit spending despite wages at record lows as a share of economy.
John Hussman spoke recently at the 2013 Wine Country conference. Here he describes the relationship between corporate profits, and government, and household savings (starting at 22.08):
Hussman’s whole talk is well worth hearing.
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h/t Meb Faber
[…] To Abandon Proven Models In Speculative and Fearful Markets: Why This Time Isn’t Different, What Record Corporate Profit Margins Imply For Future Profitability and The Stock Market, Warren Buffett, Jeremy Grantham, and John Hussman on Profit, GDP and Competition). Those posts […]
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http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=4&ved=0CEAQFjAD&url=http%3A%2F%2Fwww.academyfinancial.org%2F12Conference%2F12Proceedings%2FG4%2520Golob.pdf&ei=LtZ-UYXME4Gy2QW3jIHYAg&usg=AFQjCNETOpAurdxRmf_R8SXGuQzLWdVeRQ&sig2=r_b75YDUBbeBcXvESeduNQ&bvm=bv.45645796,d.b2I&cad=rja
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“The federal debt-to-GDP ratio has accelerated in recent years to levels unseen in the U.S. since the post- World War II decline. At the same time, the profit share of national income is at post-war highs and the employee compensation share of national income is at 40-year lows. The empirical evidence in this paper suggests that these facts are related. The paper provides evidence that government debt has crowded out business investment, which has led to a rising profit share and declining employee compensation share of income. This result suggests that the federal debt is contributing to income inequality. On the other hand, to the extent that the rise in profit share can be traced to economic fundamentals, it is likely to be more persistent than the rise in the mid-2000s, which was boosted by illusory profits in the financial sector.”
“At the end of calendar year 2011 the U.S. gross federal debt was 15.6 trillion dollars, which at 102 percent of annualized U.S. GDP is the highest since 1947. Corporate profits in the final quarter of 2011 were $1.99 trillion dollars, which at 14.6 percent of national income is the largest profit share since the Department of Commerce started compiling quarterly data on the U.S. economy in 1947. Meanwhile, the labor share of income is at post-war lows (Jacobson and Occhino, 2012). Is it a coincidence that the profit share of national income and the debt were both at 60-year highs while the labor share of income was at post-war lows? This paper suggests not. Although the rise in profit share can be partly attributed to growth in the overseas operations of U.S. corporations (Hodge, 2011), this paper presents evidence that the federal debt may be another contributing factor.”
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“Separate from the study of government debt, researchers have been trying to understand why labor’s share of income has declined and the profit share of income has risen over the last three decades. Jacobson and Occhino (2012) and Ellis and Smith (2007) discuss three potential reasons. First, researchers have suggested that wage growth has slowed because the bargaining power of unions has declined as employment in unionized sectors of the economy has declined. Second, globalization may have reduced the bargaining power of labor as low-skilled workers from China and Eastern Europe have entered the global economy. Third, researchers have suggested that technological change may play a role in changing labor and profit shares, either by increasing the productivity of capital, or by increasing the rate of worker’s obsolescence and thereby reducing their bargaining power.”
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Jeff, I see how you add the foreign profits of US firms to your numbers. Do you also pull out the US profits of foreign firms? How would this influence your calculations?
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Corporate profits don’t include U.S. profits of foreign firms. The numbers Hussman uses, or Buffett for that matter, don’t include them. So neither do I.
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Jeff, although I respect Hussman, I am starting to think that there is an apples-to-oranges problem here. If I understand the conversation correctly, then Hussman is comparing US GDP (composed of the activities of both US firms in the US and foreign firms in the US) with US profits (composed of US firms profits in the US and foreign markets.) This is not a fair comparison unless you make some big assumptions.
Do I understand your point correctly?
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Corporate profits do not include U.S. profits of foreign firms. GDP does not include U.S. profits of foreign firms. They are backed out of both. So no apples to oranges comparison.
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“GDP does not include the US profits of foreign firms.”
Perhaps you made a typo in this sentence? Did you mean to say that “GDP does not include the U.S. activities of foreign firms”? That is the only way that I can understand the statement. Unfortunately, I don’t believe that it is correct? Can you please clarify?
From my perspective there are 4 actors here:
1. US firms operating in the US
2. US firms operating in foreign countries
3. Foreign firms operating in the US
4. Foreign firms operating in foreign countries
#1 and #3 create US GDP and US profit
#2 and #4 create foreign GDP and foreign profit
I thought that I understood your complaint about Hussman, but maybe I don’t. I perceived that Hussman was comparing US GDP (#1 + #3) to US profits (#1 + #2)
Maybe I have a fundamental error in my understanding somewhere. I appreciate your patience.
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If you use GNP, then it is apples to apples – I believe Hussman uses GDP b/c there is very little difference between the two and likely is easier to obtain data for.
So with GNP you are looking purely at US company output both in the denominator and the numerator.
1. US company domestic sales (denominator)
2. US company foreign sales (denominator)
3. US company domestic profits (numerator)
4. US company foreign profits (numerator)
Using GDP it is…
1. US company domestic sales
2. Foreign company domestic sales
3. US company domestic profits
4. US company foreign profits
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Wrong. Look it up. You’ll see. They aren’t in GDP.
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Jeff,
Is your response to me? I am not sure exactly what you are referring to when you say “they aren’t in GDP.” Are you referring to my statement that I believed that foreign firm activities in the US are included in US GDP? I just looked that up in Wikipedia.
“Gross domestic product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period of time.”
If I did not interpret your comment correctly then please let me know.
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Dig deeper and you’ll see. You’re going to have to dig deeper than Wikipedia.
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Fine Keith and Joe, I was wrong. My apologies. Look at Table 1.7.5 and Table 6.16D on the BEA website for detail. So we should compare corporate profits to GNP, not GDP. I updated my charts. They have no bearing on my thesis regarding foreign profits and how they are driving the increase in corporate profits relative to GNP. Oddly enough, it actually strengthens my argument. Very slightly (0.1%). Domestic corporate profits to GNP are 5.5%, not 5.6%.
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Pg. 5 http://www.bea.gov/national/pdf/nipa_primer.pdf
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Pg. 5 here rather http://www.bea.gov/national/pdf/nipaguid.pdf
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OK, thank you. If using GNP figures, then the assumption is that US firm activities in foreign countries is approximately equal to foreign firm activities in the US. This assumption need be true for both the level of activity and level of profit. This also requires the assumption that this relationship of US and foreign firms has been constant over time.
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My reply was to Joe.
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Keith,
Regardless of where corporate profits shake out relative to GDP or GNP, all that should matter to you as an investor is where corporate profits are relative to sales.
In 2012, the S&P 500 generated sales of 1,086.40 per share and EPS of 87.65, for a net profit margin of 8.1%. For reference, 2011 NPM was 8.6%.
S&P margins are a mean-reverting series, REGARDLESS of the composition of those earnings. Ok so perhaps the “mean” is higher than its historical norm – say 7%….that means 2012 adjusted earnings were $76 per share, and assuming a 6% growth rate, 2013 adjusted earnings are $80.61.
Some would say in a no-yield environment that the fair value PE should be higher than average….well I would counter that in a NO-GROWTH environment, the fair value PE should be BELOW AVERAGE.
So say fair value is 15 times 80.61 – that’s 1,209. Perhaps 13X is more appropriate in the “Age of Deleveraging” – so 1,048.
All I know is that the market is not worth anywhere close to the current 19.8 times 2013E adjusted earnings of 80.61.
I’ll leave you with some historical data points for S&P Industrial net profit margins (i.e. excluding fins) (I am eyeballing a chart, so it’s somewhat imprecise):
1956 peak: 7.02%
1961 trough: 5.40%
1966 peak: 6.60%
1971 trough: 4.93%
1974 peak: 5.68%
1975 trough: 4.28%
1980 peak: 5.40%
1986 trough: 3.60%
1989 peak: 5.40%
1991 trough: 2.80%
2000 peak: 6.54%
2001 trough: 2.43%
2007 peak: 7.53%
2009 trough: 3.30%
2011 peak: 8.59%
1991-2011 average: 5.20%
2000-2011 average: 5.70%
1956-2011 average: 5.30%
You can come to your own conclusion as to whether there has been a sea change in margins.
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1.) Again, you aren’t understanding that adjustments that need to be made when thinking about foreign earnings and how they effect things. They are now probably 50% of S&P profits. Foreign earnings have much lower tax rates and thus higher margins. (Actually according to BEA there are no net taxes because foreign tax credits offset all the profits.) More foreign earnings means better overall margins. Also, historically low interest rates have made up 50% of the increase in margins over the last few years according to Credit Suisse. Wages and taxes need to be taken into consideration as well. Your data is not useful. Nor does it include fins. Feels to me like you presented the data in a way that supports your argument more than laying it out objectively.
2.) I’ve made the argument that Graham would never in a million years value a growth company off of 10 yr avg earnings. Nor would Buffett. Nor would anyone of any intelligence. And America is a growth company, even if it is only growing at 2% instead of 3% in real terms or 4% instead of 6% in nominal terms at the time being. If a company had earnings of $1, $2, $3, $4, $5 and $6, Graham would likely say earnings power is $7 not $3.5 (avg. of the 6 years). He also took interest rates into consideration (as Buffett has said people should do many times). And he also added a 50% arbitrary adjustment to his stock market valuation starting in the late 50s / early 60s. Here is his formula: (10 yr avg EPS / 2x Moody’s AAA bond yield) * 1.5 = Central Value of Stock Market. Now the reason for this adjustment in my mind is to make up for growth. His formula worked for 20 or 30 years when the economy was jacked up. Once it got growing normally again, the formula didn’t work. So he added the 50% adjustment. And this is why I think he did:
Cash Flow: $100
Discount Rate: 10%
Perpetuity Value: $1,000
Cash Flow: $100
Discount Rate: 10%
Growth Rate: 3.25%
Perpetuity Value: $1,481
Difference 48.1%
So for a mature business, 10 yr avg earnings is likely going to be sort of a mid-point for the business and a nice estimate of earnings power. 10 yrs picks up most business cycles so you have peak and trough earnings and the avg. should be what you want to look at. For a growth company, the analysis is different. Most people use 3.0%-3.5% for a perpetuity growth rate, so I took the mid-point of that. It assumes there will be growth of slightly more than inflation going forward. Seems safe. This is why Graham’s 50% arbitrary adjustment made sense.
($80 / (2 * 3.67%)) * 1.5 = 1,634
($75 / (2 * 3.67%)) * 1.5 = 1,532
When you value a company or an index, you have to take the present value of all future cash flows, so a perpetuity growth rate of 3.25% is justified and makes sense.
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I just said the new norm could be 7% versus the 6% historical average, and I valued the market on that.
By refuting my analysis, you must be inferring that the current 8% NPM is the new norm, correct?
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I answered it more fully below. But here are some additional thoughts. It will come down. When the economy is healthy enough for interest rates, employee comp and effective taxes rates to start going up. That could be 5-10 years. So applying a 7% margin to today’s revenue is ludicrous.
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Joe,
I don’t have a problem with your “back-of-the-envelope” valuation of the S&P. It is a reasonable logic given your assumptions. It is, in fact, quite close to my own back-of-the-envelope.
I am much less comfortable with the statement, “all that should matter to you as an investor is where corporate profits are relative to sales.” I don’t think that this is true. I don’t understand why corporate profitability is so high currently. As long as I don’t understand why it is high now, then I don’t see how I can claim that I am sure that I know where it will go. Why should it mean-revert to the 4-6% range? Why can’t the same forces that now propel it to 8% keep propelling it to 10%? Why can’t those same forces keep it elevated for a decade or more?
I recently moved to over 50% cash simply because I don’t understand the market now. (And I don’t believe Hussman’s explanation either.) The only way that I know to gain a greater wisdom is to ask more questions of other people that see things differently. Jeff’s opinion is clearly an outlier here, which is why I have wanted to understand his view.
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I was taking 10 yr avg earnings. But you applying a normalized margin to current revenue is completely useless. Unless you think a margin being driven by increased foreign profits, historically low interest rates, 40 yr low employee comp and near historical low effective tax rates will come back down all of the sudden, then your analysis is just irrelevant.
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($80 / (2 * 3.67%)) * 1.5 = 1,634
($75 / (2 * 3.67%)) * 1.5 = 1,532
So these values are based on 10-year average earnings?
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That’s what I said. Need to look at either 10 yr avg operating earnings, or 10 yr avg as reported earnings excluding 2008. $75 is the number I have generally looked at, although that is moving up. Using $70 gives a more conservative valuation.
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The cyclically adjusted earnings used in the Shiller PE are presently $68, so $70 is well within the margin of error. Those earnings are growing too. Is the only point of difference here the appropriate multiple to be applied to the market?
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And you did not answer my question – you believe the current 8% NPM is the new normal?
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I responded but it mustn’t have posted. I basically said your thought process is useless unless you think profit margins are all the sudden going to mean revert immediately despite 75 yr increasing foreign profits, historically low interest rates, 40 yr low employee comp and near historical low effective tax rates. None of that is going to necessarily mean revert other than interest rates and wages will go up when the economy strengthens, which goes against your total market implosion scenario (so basically a repeat of 2008 except with a healthy banking system this time). So your whole analysis is intellectually bankrupt. No one values anything that way. It worse than worthless actually. It’s misleading. And it is basically all you have left in your argument.
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Toby, I didn’t see your post. And I didn’t apply a multiple, although theoretically it would be the same thing. I took growth and interest rates into consideration which the Shiller PE does not. You can see my analysis above. I provided the detail.
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Jeff, at one point you propose $100 and then you seem to propose $70 or $75. I’m trying to understand which you prefer.
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The $100 was for a generic example of how value changes for growth vs no growth scenarios. And it shakes out to about 50%. Not surprisingly that is the same arbitrary adjustment Graham made to his Central Value calculation. I think it works because it captures growth whereas applying a multiple to 10 yr avg earnings does not. It would only work in the case of a mature business.
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So if we take your S&P500 fair value estimate of ~1,600, and your $80 earnings estimate, does that imply you believe that the appropriate multiple at fair value is 20?
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To stay conservative I use:
($70 / (2 * 3.67%)) * 1.5 = 1,430
Graham would come up with Central Value and give a range around it. So I think +/- 10% of 1,430 is reasonable. And we are just outside that range now. But if earnings continue to do well and the market stays flat, it will catch up.
If that all shakes out to 20x 10 yr avg. earnings, so be it.
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The growth scenario analysis is my rule for investing. A no growth mature business is worth 10x cash flow. 50% premium for a company that can grow at inflation + population growth, so if its a decent business. For great businesses, the fair value would be (10x cash flow + 50%) at a minimum. For terrible businesses, or dying businesses, they would be worth less than 10x cash flow.
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So slightly higher than 20 (1,430 / 70 = 20.4)? Does it concern you that the market has rarely traded at a multiple north of 20 for very long, even in recent times? The long-run mean is 15.5 and the median is 14.5 (see the charts at Multipl). For me, that’s the main point of departure from your estimate. I use the long-run mean and median as fair value.
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“So your whole analysis is intellectually bankrupt. No one values anything that way. It worse than worthless actually. It’s misleading. And it is basically all you have left in your argument.”
HAHAHAHHAHAHAHAHHAHAHAHAHHA and you call me rude? You pull 10 years of average earnings squarely out of your asshole whereas I actually put some thought into long-run margins and fair value PE ratios given the deleveraging environment we’re in, yet I am intellectually bankrupt? hahahahhahahahahahhahahahha
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You are a fool. You are doing the same thing everyone else is doing (i.e. adjusting margins) by using a 10-year average, then turning around and scolding everyone else for corrupt methods and thought processes. WOW.
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Toby, it doesn’t concern me due to the volume of information I have thus far provided that goes into my view. You are just looking at a multiple and calling it a day. I am digging in and looking at many other things. Taking interest rates into consideration, taking growth into consideration as Graham eventually did, thinking about corporate profits, employee comp, taxes, interest rates, the foreign profit component, etc. If you want to take the Shiller PE as the end all be all, so be it. Wasn’t it above 20x for like 20 years or something? At the end of the day, it shakes out. It is not completely insignificant, but there is much more to the story.
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Simpler models are not necessarily less predictive than apparently more sophisticated models with more inputs. Many times the simpler models are more predictive because they reduce the opportunity for behavioral errors. My objective is to find the most predictive and useful metrics, not the most complicated.
For all of your additional digging, you and Shiller essentially agree on the earnings estimate. The point of departure is the appropriate multiple to apply. Hussman and others (Butler|Philbrick, for example) have shown how predictive the Shiller PE is over longer periods of time. It will be interesting to see in the fullness of time whether your additional work yields better results. It may do so, and it will be an important contribution to finance if it does, but my general conservatism leads me to prefer older, tried-and-true models like those discussed on Greenbackd over the last month, including the Shiller PE.
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My method is quite simple. The thought process behind it and why it is justified are more nuanced. (That could be said about the Shiller PE as well). And the nuance I came up with adds value, it doesn’t detract. Regarding the earnings estimate, that isn’t really debatable. By Shiller or me or anyone. The data is the data. My point is if you are going to use 10 yr avg EPS, then you need to adjust for growth. And interest rates need to be taken into consideration.
Now people look at the Shiller PE and its implied valuation and then they look elsewhere to support that valuation. I did that as well. Corporate profits to GNP, total market cap to GDP, etc. For my method to be worth considering, the other analyses should not contradict its conclusion. And after looking at corporate profits to GNP for instance, and digging into it and looking at every component of it, I have come to the conclusion that it does support my valuation based on all the reasons I have stated in various comments (i.e. foreign profits, employee comp, interest rates, taxes, etc.). I looked at it independently and objectively. And it supports my valuation.
Looking at corporate profits to GNP without taking into consideration what I did I think leads to faulty conclusions. Looking at the Shiller PE and its implied valuation without taking into consideration growth, interest rates, etc. I think leads to faulty conclusions. It doesn’t mean the Shiller PE is completely irrelevant. There’s just more to the story. That’s all I’m saying.
And on top of all this, I have a view of how the economy works, where we’ve been, how we got here, where we are going that I take into consideration as well. That is a much more lengthy discussion that I won’t get into here. But it has some predictive qualities to it. For instance, when to cut and run if it is warranted.
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Although actually Shiller and I do disagree on the EPS. He uses 10 yr avg as reported. I think if you use that, 2008 needs to be excluded. You could also use operating earnings which exclude nonrecurring items and thus 2008 is not nearly as low so it could be left in. But this stuff isn’t an exact science. Use $70-$75. And understand that it is growing. At the end of the day, with all things considered, I feel comfortable saying the market is 5%-10% overvalued. Or it is just outside of a reasonable range. Again, not an exact science. It is a little frothy right now. Although that could change. Swings of 10%-15% could pretty much happen at any time. 5% swings are obviously more common.
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While we are talking about this, I think a person needs 3 things to have any chance at making predictions (albeit limited) regarding the market. This is a very summary form:
1.) Valuation thought model (this is everything I have been discussing, from how to come up with Central Value to thoughts on corporate profits and profit margins and interest rates)
+
2.) Psychological thought model (basically read Howard Marks’ work; his most recent memo on equity valuations is a good one and gets into it)
+
3.) Economic thought model (this comes from Dalio “How the Economic Machine Works” and then needs to be expanded on)
For the economic model, you need to understand the three main forces that drive most economic activity: 1) trend line productivity growth, 2) the long-term debt cycle and 3) the 5-8 business cycle that is driven by the credit cycle. Now, of these three models that need to be taken into consideration if you want to understand where the market may go, unfortunately the valuation thought model is the least predictive. You have to understand Soros’ theory of reflexivity, which basically says the market price action itself can actually effect the underlying fundamentals. That is important. So psychology can push it higher, that can lead to changes in the underlying fundamentals, and that can thus effect the valuation. The economic thought model is the most predictive, the psychological thought model is a major driver although somewhat unpredictable and the valuation thought model can give you a sense of where things stand, all things considered.
So where do we stand today:
1.) Valuation thought model = a bit frothy, but not that unreasonable
2.) Psychological thought model = Stage 2 out of 3 stages
3.) Economic thought model = Ok so far, be wary of transition process from govt driven economy (deficit + money printing, which is sustainable for some time further, although obviously not indefinitely) to private sector credit cycle driven economy (the normal way an economy generally works). Be wary of major changes in fiscal policy which would change the model, although gridlock makes this unlikely. Be wary of major changes in monetary policy which will be the Fed’s attempt to make the transition to private market credit creation. They need to thread the needle and tighten when the private sector is strong enough to do that. So we should be in a Stage 3 psychological state / giddy high valuation state before they attempt to do that. The very first step the Fed is likely to take is to drop the IOER rate to 0% to try and get banks to start putting more capital to work. This step should precede any increase in interest rates, and I think it will likely precede dialing back money printing. The market may correct a decent amount when that happens. They could sense it in advance and correct a bit before then. They could need more signs of tightening before correcting. Who knows. Probably depends on how giddy the market is at that time (could be 1 or 2 years off). The question is, can our private sector power through the tightening? If so, coast is clear (although it may get choppy for some time) and the Fed will have pulled off the grandest and most successful feat in monetary policy history. If the private sector can’t power through, watch out. Then we could get sucked down, which is a whole other chain off events that will be difficult to pull out of. I give that a 15%-20% chance of happening. Need housing sector to improve more before attempting all this though. And I think it is more likely we pull through because banks have so much money sitting with the Fed that when they start putting it to work, and presuming the economy is healthy enough, then we will see a miraculous recovery. A real recovery, not what we are going through now.
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Miraculous recovery entails the ‘GDP gap’ closing.
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Here is what people don’t understand about what the Fed is doing. Everyone says where does the money go? What is it doing? Just causing food and gasoline prices to spike? 1.) It keeps interest rates low by providing demand for all the supply needed to finance a $1t deficit. It is the deficit that is really powering us forward since all spending = all income (+ taxes), and the money printing allows that process to happen more effectively. 2.) So where is the money going? It’s pump pump pump pumping up into a giant reservoir of money sitting at the Fed making 0.25%. So when the Fed is ready to blow it all out into the economy, and presuming the economy is healthy enough to start taking it (more on this below), first they cut the IOER rate to 0% (I would advocate charging banks money, but maybe you do it in steps), second they start raising short term interest rates (creates demand) and then once the economy is powering forward on private credit creation like normal then the deficit will start closing naturally as the economy grows and tax revenues increase and unemployment will come down (GDP gap closes). After all this and once the coast is clear, then they start thinking about selling securities / destroying money. Whenever the economy overheats for the next 15 or 20 years they will do this.
Someone might say that won’t work because there won’t be enough demand for all that credit when it comes time to blow it all out into the economy. Right, so you create the demand. How do you create it? Raise interest rates. As soon as mortgage rates start moving up, every mortgage broker in America will start telling clients or prospective clients that you’d better buy now man or you’re gonna miss it. You’ll never see these rates again (at least not for about 75-80 more years). Anyone who was even remotely contemplating buying will figure they’d better act soon. And you can apply that to other forms of credit beyond housing. That is the thing I think most people are missing or don’t understand will happen.
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Wrong. Joe doesn’t know what he is talking about.
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Jeff – I sincerely want to thank you for coming on here almost everyday and providing the perfect representation of the consensus viewpoint. You embody every single inch of the phrase, “this time is different”, and make it come alive for all of the readers here. You must be truly enjoying the warm blanket of consensus validation as evidenced by the all time record Barron’s Big Money bullishness.
Best of luck,
Joe
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Nonsense. You and Toby incorrectly assume I am bullish. In fact, I am bearish. You and Toby incorrectly assume that arguing against the market dropping 40%-50% therefore must mean I think the market will roar forward. I have never and will never say that. I actually think the market is 5%-10% overvalued. And my views, the detailed drivers of my views, are held by a party of one: me and only me. I have had many discussions with many people like Toby who think the market will drop 40%-50% and not a single one is in consensus with me. In fact, no one has ever publicly pointed out the things I have pointed out as far as I can tell. For instance the 75 year consistently increasing foreign earnings component of GDP that Toby thinks will magically all of the sudden just start heading down and mean revert or something. This 75 year ski slope will mean revert. Maybe our factories around the world will just start getting torn down or something. Who knows. One can dream. So anyways, thanks for your thoughts Joe. Best of luck.
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I have no opinion on your view, other than that I cannot understand it at all. I’ve extended an invitation for you to present your thesis here.
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Your viewpoint of margins being permanently higher is 100% the consensus viewpoint. Your nonsensical explanation for such is unique to you, I will give you that.
But by saying you are bearish, you now have a put….when the market is substantially lower in a couple of years, you will be able to claim that you were not necessarily wrong and that factors nobody could have predicted led to the decline. Thus we will have been wrong in that we didn’t predict precisely what led to the decline and you weren’t wrong in your ambivalence.
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Toby, what is difficult to understand? Foreign profits compete for all non-U.S. income, so a huge number, and it isn’t mean reverting in the same way domestic profits are, which compete for U.S. income with employee comp, renters income, interest income, taxes, etc. Therefore, domestic profits need to be looked at on their own to see where they stand relative to historical levels. And they are at about 5.6% of GDP, well within the 4%-6% range. Anyone can understand that. You do have an opinion; you don’t think what I am saying has merit because you think a 75 year ski slope will mean revert. But not understanding it isn’t an option. You are smarter than that.
And Joe, you are wrong. Never once did I say margins are permanently higher. I said one needs to look at domestic profits, which are mean reverting, on their own to get a sense of where things stand. I said foreign profits are not mean reverting in the same way. Foreign profits may be permanently higher, but not domestic and thus not total. And foreign profits have been increasing for 75, so if you want to wait for them to mean revert then you may wait awhile. And if you understood why domestic profits do mean revert, then you would know why foreign profits won’t. And that you say it is nonsensical says more about you than me. What I propose is simple to understand. Those that don’t understand it are being willfully ignorant, or just aren’t that bright.
I am saying I am bearish because I have my own way of coming up with an appropriate value for the stock market. It is completely independent from all this. My analysis is my analysis, it is not a hedge. Again, you want to treat my disagreement that the market will drop in half into me being bullish. I am not. And regarding the market being lower in a few years, I do have a sense on what those factors will be. Too much to explain here.
The only way for you to be right is if the market drops in half from today’s level. So about 750-800 on the S&P. And we will likely never see those levels ever again. So, you will be wrong under any scenario basically.
You know what I don’t hear? I don’t hear a refutation of my argument other than I don’t understand, that doesn’t make sense, that is right, but Hussman says, yada yada yada. How about telling me why foreign profits will mean revert? That might be a better route if you want to propose a convincing refutation of my thesis.
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“So about 750-800 on the S&P. And we will likely never see those levels ever again. So, you will be wrong under any scenario basically.”
I love that you said this too – I look forward to discussing S&P 800 with you right here on this board :D
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I love that you love that I said that. You are crazy if you think the S&P will get down that low again. Have fun sitting in cash waiting for that to happen. :D
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This is good by the way. http://www.marketfolly.com/2013/03/oaktrees-howard-marks-equities-in-stage.html
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Maybe I have to be more clear. ‘Total spending’ or ‘total income & taxes’ (both separately add up to GDP) is going to be fairly set this year around $16 trillion or a bit more. Not much is going to change that. So if domestic companies built a bunch of new factories in the U.S., big deal. They are still fighting for the same piece of pie (income). The only way for domestic profits to get more pie no matter how many new factories are built is to essentially eat into wages, or for taxes to come down, or if interest rates come down, etc. For foreign profits the dynamic is totally different. U.S. headquartered companies could set up more and more factories overseas each year and continue to increase the foreign profits component of GDP. What is difficult about that?
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$1 of GNP via a Nike factory built in China or the United States is the same $1 of GNP. Nike may get a better margin on its Chinese investment due to low-cost labor….but as mean reversion rears its nasty head, those margins will compress as low-wage Chinese workers demand higher wages. We’re seeing that already over there. Margins compress, then Nike begins investing capital into the next low-cost area of the world….say Mexico. Then the cycle begins anew.
Hussman’s chart showing the extremely tight correlation between gov’t/household dissaving and corporate profits is perhaps the most compelling chart in finance today. At a -12% annual loss per annum for the next three years, SPX earnings will fall from $90 in 2012 to $61 in 2015 or thereabouts.
I look forward to the market being at 918 and Barry Ritholtz’s new catchphrase being, “Stocks are cheap at 15X earnings with the Fed printing money.”
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You don’t get it. We can’t grow in the U.S. like we can outside of the U.S. Setting up a bunch of factories in the U.S. won’t necessarily lead to a much higher domestic profits number because it competes for a set amount of pie (income). Yeah it can grow if there is demand and it can hire otherwise unemployed people thus increasing total spending/income. But companies aren’t doing that. The U.S. has a ton of capacity as it is. Look at the ‘GDP gap.’ Growing internationally is different. You are focused on foreign profit margins which is different from foreign profits to GDP. I am focused on the fact that if U.S.-headquartered companies continue to expand globally, then it doesn’t matter whether foreign margins are 12%, 8%, 10% or whatever because total foreign profits to GDP will continue to increase just like they have for the last 75 years. A nice upward ski slope that clearly is not mean reverting. Not ‘maybe it will,’ not ‘well what about this,’ it isn’t. It simply isn’t. Look at the chart. Look at the data. It is quite simple to comprehend.
Hussman’s chart showing the extremely tight correlation between gov’t/household dissaving and corporate profits is not the most compelling chart in finance today. It is his failed attempt at justification for his poor performance. There are many other more important factors driving domestic profits to 5.6% of GDP. Like employee comp coming down, and historically low interest rates, and effective tax rates being close to historically low levels. How is GDP calculated?
Income approach to GDP = Employee compensation + Corporate profits + Proprietor’s income + Rental income + Net interest + Taxes less subsidies on production and imports.
So if employee comp comes down, that spending/income will get redistributed somewhere else. Think it will go into rental income? Of course not. Net interest? Clearly not. Taxes? Don’t be silly. Corporate profits or proprietor’s income? Ding ding ding. Think Hussman will talk about that? Of course he won’t. Does he know about it? Absolutely. So he is deluding himself.
You have fun staying in cash for the next 3 years then. I don’t think many people would consider an investing strategy that merely waits for recessions before investing to be very sound.
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“You are focused on foreign profit margins which is different from foreign profits to GDP”
Profit margins is ALL that matters. Who cares how the profit/GDP figure shakes out?
If 40% of SPX revenue of 1,080 per share comes from overseas, and that low-cost labor starts to go away, the $90 of aggregate earnings will begin to decline.
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Facepalm. Foreign profits are clearly not all that matters. Foreign profits to GDP and foreign profits of S&P companies can still go up in aggregate no matter how foreign profits margins fluctuate. Come to think of it, this has been the case for 75 years! Case in point: a 75 year upward ski slope of foreign profits. That chart is not mean reverting.
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And another comment on Hussman’s chart. I am not saying savings are irrelevant. I am saying there are many other factors that need to be taken into consideration. But let me pose you this challenge. Clearly you must agree that govt + household savings should have no effect on foreign profits since foreign profits are derived from non-U.S. income streams. Only a fool would think otherwise. So redo the chart he put together and back out foreign profits and see how the correlation looks. I challenge you to do that.
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You do realize that the current account deficit is part of the savings equation, correct?
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Pull out foreign profits in that chart and see what you get. I challenge you.
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From Hussman:
“Profits = Investment – Household Saving – Government Savings – Foreign Savings + Dividends
Some might object that this is simply an identity (true by definition) and doesn’t imply causality. That’s a reasonable point, but as with all analysis, it’s not enough just to toss out an objection and walk away – you’ve got to go to the data and find out the truth.”
It is a reasonable point. And he’s right, it isn’t enough just to toss it out. However, it is enough to mislead. Foreign profits are flowing through the Foreign Savings component. Which makes his chart a total joke. 40% of corporate profits are foreign profits. And they don’t play into govt + household savings at all. But he is still comparing the two. Pure intellectual bankruptcy.
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Actually foreign profits would also flow through Investment and Dividends
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Yeah Joe, foreign profits are tripled counted. Good thinking. And cute second comment from you. Now you are ad hominem attacking me? I’m just a dummy? Please. Any analysis that doesn’t look at domestic profits on their own is worthless and misleading.
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McDonalds is a multi-national corporation, last I checked. They pay out about 50% of earnings as dividends. The other 50% has to show up somewhere in the Kalecki equation.
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Hussman compares corporate profits (which include foreign profits) to govt + household savings (which don’t include them). Therefore, his chart is useless. And I already discussed the real drivers of corporate profits: wages, interest rates, taxes, etc.
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He explains why here….
http://hussmanfunds.com/wmc/wmc130408.htm
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Foreign earnings aren’t in govt + household savings. They are in corporate profits. Thus his chart is useless. Come on man, this isn’t that hard.
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Despite the enormous weight of both accounting identity, historical data, and simple arithmetic, we continue to encounter persistent hostility to the idea that profit margins are the mirror image of extraordinary and unsustainable deficits in the government and household sector. The actual relationship was first detailed by the economist Michal Kalecki in the mid-1900’s. James Montier of GMO gives a nice derivation. The full relationship is:
Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends
As I noted over a year ago, dividends exhibit very little volatility over time, and do not exert a material amount of volatility in the above relationship over the course of the economic cycle. It also happens that particularly in U.S. data, the difference between Investment and Foreign Savings (i.e. the inverse of the current account deficit) also fluctuates relatively little, because current account “improvement” is typically associated with deterioration in gross domestic investment, as shown below in data since the 1940’s.
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Thanks. I can read. I provided you with the insight into understand corporate profits to GDP. He is wrong. Or rather he is missing some things. He’s a great example of when intelligent people do dumb things. There must be some wisdom in the folk saying, ‘It’s the strong swimmers who drown.’
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“He is wrong. Or rather he is missing some things. He’s a great example of when intelligent people do dumb things. There must be some wisdom in the folk saying, ‘It’s the strong swimmers who drown.'”
Thus implying you are the “weak” swimmer in this discussion?
Hussman has nothing to gain by making things up – his investor base has obviously stuck by him for a reason….he has a long-run established track record based on a well-tested, and well-proven methodology. Yes I personally believe he could incorporate some other factors into his analysis….but he will be proven right.
People berate him for pounding the table on the market being overvalued in 1996 because it went on to more than double by 2000….
The market closed on 12/31/1996 at 741 while the 30-year US treasury bond yielded 6.65%. By 12/31/2008, the market was at 903.25 and the US 30-year treasury bond at 2.69%.
So in 12 years, the S&P 500 returned 1.66% per year before dividends v. 3.8% per year for the 30-year bond….BEFORE reinvested interest payments, which started out at a 6.7% yield at 12/31/1996.
So add 6.7% to the bond return, for an approximate 10.5% annual return over 12 years, and add say 3% onto stocks for a 4.66% annual return!!!
But ya Hussman is the “strong swimmer” doctor who doesn’t know what he is talking about.
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I took that quote from Munger. Are you saying he is a weak swimmer? Nice petulant comment by you though. Clearly things haven’t been going well for Hussman, implying a flaw in his methodology. The guy has been bearish since the bottom. He is losing respect by the day. It’s not my fault.
Sounds like you must work with him or something. Well, hopefully he hasn’t been managing your money.
Try reading Howard Marks instead. You’ll find it much more useful.
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I would also refer you to Montier’s work on margins…
Click to access Montier%20-%20What%20goes%20up%20must%20come%20down.pdf
But I assume you are smarter than him as well so his analysis is likely moot.
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When Hussman’s assets go to zero, that’s when his market call will be right. So maybe in a year or two, people will finally give up on him, that’s when it will make sense to get short. Would be funny to see him on CNBC or Bloomberg in 2015 or something screaming I was right darn it, I lost 50% over x years but would have had a +25% over the past 6 months…
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I think it’s fair to say most have given up on him now. I’ve never seen a positive comment about Hussman on this site, but most fetishize outcomes over processes.
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If a process doesn’t produce superior results, then there is likely a problem with the process. Or at a minimum it is useless/irrelevant. There is something he is missing. Something he doesn’t understand. Or maybe he is interpreting something in the wrong way. I have my thoughts, but I’m sure we’ll find out down the road. If the ‘GDP gap’ closes before some large calamity (i.e. change in fiscal policy to close the deficit too quickly, or the Fed tightening too aggressively and too early), then he is toast.
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Hussman is great to invest with if you want to lose money over 5 years, or badly trail T-bills over 10 years.
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I like his process. He was too bearish in March 2009 and October 2011, but his process is otherwise sound. In any case, it’s not fair to judge him mid-cycle. Peak-to-peak or trough-to-trough is the only way to see who’s been swimming naked.
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So wait until the next recession when the stock market correct 30%-40%? I don’t think that would be validation since the stock market will definitely correct that amount during the next recession regardless of whether things are overvalued or undervalued in the interim. And when the market does have that correction, he likely won’t generate enough gains from it to lead to a record that beats the S&P over that time period. Five years of really underperforming the averages will be tough to make up unless he is 100% short at just the right time. Which he won’t be. And of course you know my views as to why he has his corporate profit analysis wrong. At some point he is going to have to justify his poor performance, and so he will have to talk all about foreign earnings. He sees it now. He knows. He is just deluding himself for the time being.
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