This week's Barron's interview featured Jason Trennert of Strategas Partners. Jason is bullish about the U.S. market and bearish about emerging markets. Much of his logic is sound, and his conclusion is fine--the U.S. market goes up about two-thirds of the time, so predicting it will go up this year is rarely a dumb bet. One of Jason's points is flawed, however:
We expect $93 for S&P 500 operating earnings in '07, and that puts the market at roughly 15 times earnings...The downside risk is low because P/Es are so low.
P/Es are not "so low." In fact, they're not even "low." To get to "15-times earnings", Jason is looking at "forward operating earnings" (an estimate). He's then comparing it to last-twelve-months earnings. Cliff Asness has written in detail about the folly of this apples-to-oranges comparison. According to Cliff, the average "forward operating earnings" P/E is about 11-times, not the 15-times that Jason and other contemporary bulls throw around. This 11-times, moreover, is an average--so half the time the market's P/E has been below this level.
And then there's the profit-margin problem. As discussed often in this forum, profit margins are 50% above their long-term average and at 50-year highs. To compare today's P/E multiples to historical average multiples, you have to believe that today's profit margins will stay where they are. Anything's possible, but this seems extremely unlikely. At the very least, the profit-margin question is deserving of 1) acknowledgement, and 2) an explanation. In Barron's, anyway, Jason didn't have either.
The market may go up, but, if so, it won't be because P/Es are low.
I very much enjoy this website but I hope you don't mind, as one of its subjects, my posting a comment or two on your critique. Your point on margins is well-taken, but your readers should understand that that there is limited time and space to discuss all the nuances of one's views in such interviews, especially when speaking about something as broad as the stock market. I was unfortunately not asked about profit margins in my interview with Barron's but, as any one of our clients knows, we have written extensively about the subject. There are many astute market observers that have rightfully pointed out that profit margins have been mean-reverting in the past. Although it's always dangerous to say it's different this time, it seems clear to us, after nearly three years of profit bears claiming that the end was nigh, that something has changed. In our view the the double-barrelled secular changes of technology and globalization have made margins stickier, longer than the consensus would have ever thought possible. This is simply because companies have a better chance of arbitraging unit labor costs today than they have ever had in history. Labor costs comprise about two-thirds of total costs for the average company. With a seemingly limitless supply of labor in India and China, there has never been a better time to be an owner of a business or for companies to maintain margins. This has also been true, to a remarkable extent, in the service sector. Goldman Sachs' third largest branch office, as an example, is now in Bangalore. The greatest risk to profit margins, therefore, is not labor unrest, as it might have been in years past when labor markets were less fluid, but political efforts aimed at slowing the forces of globalization.
Posted by: Jason Trennert | May 28, 2007 at 08:47 PM