INVESTMENT INTELLIGENCER

Jason Trennert Responds: High Profit Margins ARE Sustainable

A few weeks ago, I took issue with Jason Trennert's argument in Barron's that today's P/Es were "low."  I felt that, like many other analysts, Jason had not taken into account the likelihood that today's record-high profit margins would eventually revert to the mean.  Here, Jason responds directly to that criticism:

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.

In the hope of prompting an additional thoughtful response from Jason (or another reader), my concern with the argument above is that it doesn't explain why companies won't begin to pass through these labor savings to customers, in the form of lower prices.  For a temporary period, the companies that are the first to exploit lower labor costs will benefit from higher margins and lower prices than their competitors, but over time, the competitors should follow suit--until outsourcing labor to Asia and India becomes not a competitive advantage but a competitive necessity.  Also, companies should begin to take market share by reducing prices, which will also put pressure on margins. 

So, bottom line, I agree that the massive reduction in labor costs from globalization should drive temporary margin gains (which I think we're seeing), but I don't understand why this should be expected to continue indefinitely.

Siegel Rebuttal, Part 1:

As described in the prior post, Jeremy Siegel made several arguments intended to refute the theory that U.S. corporate profit margins will soon regress to the mean, taking stocks down with them.  One of these arguments was that the percentage of overall U.S. profits captured by corporations vs. private entities is very high, so overall U.S. profitability is not, in fact, extreme.  The following email (from an independent analyst) suggests that this argument, at least, is a hallucination:

It’s hard to know where to begin with Siegel, but I have to start someplace, so I’ll pick his point that looking at corporate profits alone gives an inflated picture of overall profit growth, since capital has shifted to corporate ownership.  Here’s a useful chart from the Federal Reserve Bank of St. Louis (click here and see the second row down: Selected Component Shares of National Income.  Also note the third row, which contains the data everyone else is focused on Corporate Profits as a percent of GDP):

Yes, proprietor’s income has grown more slowly than corporate profits.  But looking at the two together, it’s clear that overall profit (as Siegel defines it) is at or close to a high, at least since 1981.

Siegel Fires Back: Bullish And Proud Of It

Jeremy Siegel's latest column in Yahoo Finance responds to John Hussman and others, who argue that Siegel's irrational bullishness is setting him up to be come a modern-day Irving Fisher.  Siegel's response: The critics are wrong, profit margins are fine, valuations should be higher, and stocks are going up.

Siegel's main arguments are these:

• The hand-wringing about "record-high profit margins soon reverting to means" is misplaced because 1) a greater percentage of U.S. corporate profits are coming from international operations, which aren't affected by U.S. GDP, and 2) a greater percentage of overall U.S. profits are now captured by public U.S. companies instead of private ones.

• Innovations in the financial system, namely lower trading costs and smarter central banks, have reduced the equity risk premium.  Thus, stocks should now trade at an average P/E of about 20-times, instead of the long-term average of about 14-times.

Siegel, in other words, believes that "it's different this time."  And that's reasonable--because sometimes it is different this time (the most salient example being a permanent change in the relationship between bond yields and dividend yields after the U.S. went off the gold standard--a change that cost many "prudent" investors to miss decades of gains).  Of course, more often than not, it's NOT different this time, and those who argue that it is end up with egg on their faces (believe me--I know).

I'll wait for Hussman, Grantham, Smithers, DeLong and others to respond to Siegel's arguments before taking a strong stand here.  I will simply suggest that the big lesson from most major bull markets is this: anytime someone argues that "it's different this time," the burden of proof ought to be on them (as opposed to on bears who appear to be "wrong" because the market keeps going up). With this in mind, I'd like to see more data from Siegal backing up his profits argument--a chart showing the percentage of U.S. profits generated from international operations over time, for example, as well as a chart of global profits relative to global GDP (are profit margins at record highs globally, as well?). 

The "risk premium" argument obviously won't be settled until after the fact, but in my mind there's an easy counter to that one: Today's risk premium is low because stocks haven't been that risky recently--even with the crash of 2001-2002, global equities are sharply higher than they were 10 years ago.  Go through a couple of decades of stagnation, meanwhile, like the periods that followed market highs in 1929 and 1966, and investors won't give a damn about low transaction costs or more enlightened central banks.  Instead, because stocks will seem like the worst investment idea anyone ever thought of, investors will once again demand a huge equity risk premium.

Warren Buffett: Buy Low-Cost Index Funds

The Oracle delivered some secrets of intelligent investing in a press conference following the Berkshire Hathaway annual investor meeting:

• Buy low-cost index funds, which will outperform the majority of other investors (the vast majority).
• Avoid hedge funds.

Buffett also said he hoped that Berkshire would outperform the S&P by a couple of percentage points (which wouldn't be surprising, given the value effect).  He added that he would be "amazed" if Berkshire did any better than that.

Jeremy Siegel: The "Irving Fisher of the 21st Century?"

In his latest weekly letter, fund-manager John Hussman posits that Jeremy Siegel, the famous finance professor known as the "wizard of Wharton," is well on his way to becoming the Irving Fisher of this era.  Fisher, you may remember, was the well-regarded economist who opined in early September 1929 that stocks had "reached what looks like a permanently high plateau."  As Siegel himself noted in his excellent Stocks for the Long Run, Fisher made this remark two weeks before the start of The Great Crash.  Soon thereafter, his reputation was forever destroyed.

Siegel hasn't said that stocks will never again fall, but in Hussman's opinion, he's now stretching his bullish interpretations so far that he's making methodological errors.  Hussman cites a Financial Times piece in which Siegel argues that "Real returns can be estimated from the earnings yield, the reciprocal of the more popular price-earnings ratio. Since stock earnings are based on real assets, the earnings yield provides a good estimate of the real return on the stock market.”  Siegel then uses this logic to suggest that stocks may produce even higher returns in the future than they have in the past.

Hussman, also a finance PhD, has a number of problems with this logic, starting with the fact that Siegel is equating earnings with dividends.  He also ignores that 1% of stock performance over the past 80 years has come from multiple expansion, compares apples with oranges by conflating trailing and forward P/Es, and ignores that profit margins are at currently at record highs (thus producing artificially low P/Es).

This latter omission is the part of Siegel's bullish argument that I find inexplicable.  As Jeremy Grantham has observed, earnings are "one of the most dependably mean-reverting series in finance."  It would be one thing if Siegel were to acknowledge today's record profit margins and then argue that this time they won't revert to historical means.  But he doesn't even acknowledge them!  Instead, he just takes a simple current P/E and compares it to a century average based on average profit margins.

If Siegel weren't so smart and well-informed, this omission might be understandable.  In fact, he is one of the world's foremost market experts and a good friend of Yale professor Robert Shiller who popularized the "cyclically adjusted P/E".  So the only conclusions that one can draw are either that 1) Siegel doesn't think profit margins will drop (an argument radical enough that it deserves to be made explicitly), or 2) he is now so wed to his bullishness that can't let it go (wouldn't be the first time this has happened to a market guru...).  A third, more negative interpretation is that now that Siegel is an advisor to ETF vendor WisdomTree, he can't afford to be publicly bearish because it would be bad for business.  I'll give him the benefit of the doubt on that one.