December 18, 2012
Many people worry that market prices are artificially elevated now because of Fed policy or that our excessive debt will eventually force prices lower. What advice would you offer to those investors?
The prices of bonds are being sent artificially high, and that is where the real concern is. We’re in the biggest bond bubble in history right now, even greater than the bond bubble right after World War II, when rates were also kept artificially low. The danger is definitely on the bond side, with stocks still selling below 15-times earnings. Earnings estimates for this year look pretty much like 100 per share, and for next year operating earnings look like 105 to 107 per share.
For those people who ask, “Well, what happens if interest rates go up?” one should remember that bull markets are never killed at the beginning of an interest rate up-cycle. Those markets usually go on for many months if not years after the increase in rates. Only when rates get very high and the squeeze gets very hard does that signal the end of the bull market, so I do not fear higher rates. In fact, if the Fed forces higher rates, in my opinion that’s a sign that they think the economy is improving and it would actually be a favorable sign for the market.
Corporate profits are up about 8.7% since a year ago, and reported earnings per share for the S&P 500 are at an all-time high. To some degree, this has distorted Shiller PEs to the upside, whereas there was a downside distortion during the financial crisis in 2008, as you have correctly pointed out. Now, Jeremy Grantham of GMO has warned that profits are eventually going to revert to the mean, at least over the long term, and he uses a seven-year time horizon. What is your feeling about an eventual reversion to the mean for profit margins and corporate profits?
You’ve got to be very careful about that. Profit margins are high, but they’re not at an all-time high. There are two very good reasons why profit margins are high. One is because the percent of profits coming from foreign sales is a steadily increasing fraction, and the margin on foreign sales is higher, probably because the tax rate on foreign sales is lower. It’s often been advertised that our corporate tax rate is the second-highest in the world. In fact, even Obama has proposed lowering our corporate tax rate. So one of the reasons the margin is high is foreign sales.
Another is the growing importance of technology sales, which automatically have higher margins because of the way accountants expense R&D. It looks like they’re getting higher margins because of the fact that so much of their cost structure is in development costs. It looks like their margins are high. Technology is going to continue to be a strong part of the S&P, so I don’t see that reverting to mean nor do I see foreign profits reverting immediately to the mean.
So I’m very skeptical that we’re going to get a big reversion of profit margins to the mean. They’re high, and they’re going to stay higher than normal. Corporate profit as a percent of GDP is distorted because more firms are being classified in the corporate sector and less in what’s called proprietors’ income or private income. The return on total capital, both public and private, is not rising as a percent of GDP. What we see rising as a percent of GDP is corporate, because more firms are incorporating and we have less proprietors’ income than we used to in the economic data.
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