Record Margins in the Weakest Recovery Since the War

U.S. corporate profit margins sit at the highest level ever recorded in the national income data, roughly 10% of sales by the latest reading (September 2011). That would be unremarkable in a boom. It is strange in the weakest economic recovery of the postwar era.

Plenty of investors look at the S&P 500 and see a market that is fairly priced. The simple trailing P/E is around 15x, which is close to the long-run average of 14x for 1926 to 1999. Nobody would call that a bubble multiple.

The trouble sits in the denominator. A P/E tells you what you pay for the earnings of the last twelve months, and it says nothing about whether those earnings are normal. GMO's James Montier, in a March 2012 white paper, argues that they are far from it, and that the gap between the market's headline valuation and its cyclically adjusted valuation explains nearly all of the difference.

Take the Graham and Dodd P/E, which divides price by a ten-year moving average of earnings. It reads around 24x against the 15x trailing figure. The nine-turn difference is a measure of how far current profits have run ahead of their own history.

Why Mean Reversion Is Always a Bet Against a Structural Break

GMO believes in mean reversion, and Montier is candid about what that belief costs. Anyone who bets on reversion is, by construction, short a structural break. If margins have moved to a permanently higher plateau, the bet loses.

The sensitivity here is large. GMO's seven-year real return forecast for the S&P 500 assumes margins fall from 7.8% (their starting level on the company-reported basis) to 6.0%, with the P/E settling at 15x. Under those assumptions the forecast components are real sales per share growth of about 2.4%, a dividend yield of 2.9%, and a margin drag that pulls the total down.

Now suppose margins stayed where they are. The forecast would rise to about 4.5% a year in real terms. That gap, a couple of percentage points annually, is the price of being wrong about reversion, and it compounds over seven years into a meaningful difference in ending wealth.

So the honest approach is to hunt for reasons the break might be real. Montier does not wave the question away. He goes looking for a framework that explains profits from the top down, and he finds one in an older tradition of economics than most finance courses teach.

There is also a sobering data point on the other side. Wall Street analysts expect margins to keep climbing through 2013, past the average level seen in the bubble years. Extrapolation of that kind has a long record of being wrong, which is a small comfort to anyone betting on reversion.

The Kalecki Identity and What Really Pays for Profits

Michal Kalecki, a Polish economist and contemporary of Keynes, built a profits equation from national income accounting. Jerome Levy reached it about a decade earlier, and Keynes arrived at a version too, so economists found the idea at least three times.

Start with a closed private economy, no government and no trade. Income equals expenditure. Income splits into profits and wages, and spending splits into investment and consumption, so profits plus wages equal investment plus consumption.

We rearrange and note that household savings equal wages minus consumption (assuming no dividends). Profits then equal investment minus household savings. It is an identity, true by construction, but because profits are a residual left after firms pay workers and suppliers, we think it is reasonable to read the right-hand side as the driver.

Open the economy up and the equation grows: profits equal investment, minus household savings, minus government savings, minus foreign savings, plus dividends. A government deficit is negative government savings, so it adds to profits. A trade deficit is likewise a positive for domestic corporate profits.

The intuition is easy to hold. When households save more of their wages, less of the money firms pay out comes back to them as sales, so profits fall unless something else fills the hole. Investment, deficits and dividends fill it.

What the Sectoral Balances Say About the Current Margin

Apply that to 2011 and the recent record starts to look less like corporate genius and more like an accounting consequence. Federal deficits were running at levels not seen outside wartime. Households were saving more than they had in the prior decade as they repaired balance sheets. Under the identity, large government dissaving and a supportive trade position help prop up profits while wages languish.

That matters because it describes margins as something other sectors are financing. A weak recovery with stagnant wage growth squeezes labor's share of income, and the mirror image is fat profits. Both are consistent with the same identity.

Now ask whether those supports last. Fiscal austerity, if it arrives, shrinks the deficit and with it a source of corporate profit. Household saving cannot fall much further without credit expanding again. And a labor share at multi-decade lows invites political and competitive pressure to rebalance.

Consider a rough illustration. If the combined government and foreign contribution shrinks by 2% of GDP while investment stays flat, aggregate profits fall by about that same amount of GDP, which on a corporate profit base near 10% of GDP is a fifth of earnings. That is a stylized number, not a forecast, but it shows how quickly a margin can move once the funding changes.

This is also why the single-company view of margins can mislead. One firm can lift margins by cutting wages. All firms together cannot, because the wages they cut are the sales they lose, and the identity says profits must come from elsewhere.

Where This Leaves MS, C, QUAL, VEA and EEM

For a portfolio, the first implication concerns U.S. large caps, since that is where the margin is stretched. A broad U.S. index fund owns earnings that are cyclically inflated. The quality-factor fund QUAL tilts toward firms with high return on equity, stable earnings and low leverage, which may hold up better if margins compress, though high-margin businesses are the ones a reversion story hits hardest. Quality defends against balance-sheet stress, not against a market-wide margin reset.

Financials deserve a separate look. Morgan Stanley (MS) and Citigroup (C) report earnings that depend heavily on trading revenue, credit costs and regulation, and both were still earning well below pre-crisis norms in early 2012. Their profits are not at record highs, so the reversion argument bites less, though the same slow-growth, low-rate environment and the same fiscal questions affect them.

Outside the U.S., the case looks different. Developed markets ex-U.S., represented by VEA, and emerging markets, represented by EEM, did not see the same margin surge, and their cyclically adjusted valuations were lower than the U.S. figure. GMO has argued for years that a lower starting price is the best predictor of a better seven-year return.

The risks are real on both sides. Foreign developed markets carry the euro crisis, and emerging markets carry growth and policy risk plus currency swings. A U.S. investor moving money abroad takes on volatility that can overwhelm a valuation edge for several years.

Run a simple scenario. Suppose a portfolio holds 100% in a U.S. index with a forecast of 0% to 1% real, and shifts 30% to VEA and EEM with a combined forecast of 4% to 5% real. The blended expectation improves by roughly one percentage point annually, while the tracking difference versus a pure U.S. benchmark could be large in any single year.

Putting a Margin View to Work Without Betting the Portfolio

Timing a mean-reversion call is hard. Margins stayed elevated through much of the 1990s boom and anyone who left early gave up years of returns. GMO frames its numbers as seven-year forecasts for that reason: reversion is slow and irregular, and it can come as a sharp drop in a single recession.

A reasonable approach is to move in increments rather than all at once. An investor who wants to lower U.S. exposure might trim it over four to six quarters, directing the proceeds to VEA and EEM or to cash and short bonds. That limits regret if the structural-break camp turns out to be right.

Track the drivers instead of the margin. Watch the federal deficit as a share of GDP, the household saving rate, and the labor share of income. If the deficit narrows sharply without private investment picking up, the Kalecki identity says profits will feel it. If corporate investment rises strongly, that supports earnings for a while.

Taxes and costs deserve attention too. Rebalancing in a taxable account realizes gains, so it makes sense to direct new contributions and dividends toward underweight areas first, and to use retirement accounts for larger shifts. Expense ratios on broad ETFs like VEA and EEM are low, but emerging-market funds can carry wider bid-ask spreads during stress.

One more practical caution: this view can be wrong for a long time. A position sized so that a flat-margin outcome, with that 4.5% real return, would be acceptable is a position you can hold with some patience.

A Short List of Things to Do This Quarter

Start by looking at your own U.S. equity weight and asking how much of its earnings you believe are normal. If you think margins revert to 6%, you should expect low single-digit real returns from the S&P 500, and your plan should not rely on more.

Next, compare the cyclically adjusted valuation of your holdings with the simple trailing figure. Where the two diverge by many turns, as they do for the U.S. market (15x against 24x), be skeptical of the cheaper number.

Then decide how much room you have for international exposure, and build it in steps. Using VEA for developed markets and EEM for emerging markets keeps costs low, and a starting shift of five to ten percentage points is a sensible first move for someone who is currently overweight the U.S.

Finally, set a few triggers you can check each quarter: the federal deficit trend, the household saving rate, and the reported profit margin itself. If margins keep rising while those supports weaken, revisit the sizing. If the deficit narrows and margins hold, take that as evidence that the break may be real, and be willing to say so.

Montier's argument is a reminder that profits are not a law of nature. They are a share of income that must be paid for by someone's spending, and when the payers change their behavior, the share changes with it.