All year long, corporate earnings have been the rationale for lower stock market valuations. Typically, the arguments go something like “earnings are strong… earnings are increasing… earnings are making new highs.” And while those things are true, nobody is talking about where the earnings are coming from. Fortunately, there are some seasoned-pros, like Jeremy Grantham at GMO, who read between the lines and are kind enough to share their insights.
There are basically two ways to increase earnings (aka the bottom line), through revenue (aka the top line) or margins (the in between). Since GDP growth (and thus revenue) has been lackluster since 2008, earnings growth has been dominated by margin expansion. In other words, companies have been squeezing earnings out of revenues by cutting expenses (notice unemployment is still above 9%). The result has been some of the highest corporate profit margins we’ve ever seen in the US, shown in Figure 1 below.
At around 9%, profit margins are now 50% above their long-term average levels, and close to where they were prior to the financial crisis (the prior peak). I’ve heard people argue that margins are more trend reverting than they are mean reverting. Whatever the case, they are currently above both measures, and so it’s reasonable to say that current profit margins don’t look sustainable.
Those who think stocks are cheap are implicitly assuming that either margins will expand further or revenues will increase. We just reviewed those margins, and given that GDP growth has slowed to a virtual standstill (revised to 0.4% for Q1), it doesn’t look like revenues are coming to the rescue either.
Case in point, stocks may not be as “cheap” as some believe. Cheap or not expectations are often incorrect, and what looks cheap based on today’s forecasts may end up being expensive based on tomorrow’s realities. To wit, going into 2011 the consensus on “the Street” was that stocks would handily outperform bonds. Year to date, US stocks are down about 5%, meanwhile bonds are up about 4% – go figure.
Victor K. Lai, CFA
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