Grantham, Hussman and Montier on Profit Margins

“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” – Jeremy Grantham

That was a winner of the prestigious Climateer Line of the Day (CLoD) back in April 2011.
Here's the latest from World Beta:

The Margin Debate

One of the more interesting debates regarding stock valuations is the state of profit margins.  One one side you have Hussman and GMO lining up, and on the other Siegel and Redleaf.

I’m on the side of the former, and this is one of the reasons we have moved the majority of our equity allocations to foreign markets (valuations being another).

Below is the chart of profit margins and future profit growth from Hussman:

“What’s going on here is that profit margins have never been wider in history. But profit margins are also highly cyclical over time. The wide margins at present are partly the result of deficit spending amounting to more than 8% of GDP – where government transfer payments are still holding up nearly 20% of total consumer spending, and partly the result of foreign labor outsourcing (directly, and also indirectly through imported intermediate goods) which has held down wage and salary payouts. Indeed, the ratio of corporate profits to GDP is now close to 70% above its long-term norm.

Now, if you look at the red line (right scale, inverted), you’ll notice that unusually high profit shares are invariably correlated with unusually low growth in corporate profits over the following 5-year period. Thanks to continuing deficits and extraordinary monetary interventions, this effect has been largely postponed in recent years, allowing profits to expand to present extremes. We are not arguing that profit margins necessarily have to decline over the near-term, and our concerns don’t rest on the assumption that they will. It is sufficient to recognize that the bulk of the value of any stock is not in the early years of earnings, but in the long tail of future cash flows – especially if payouts are low. Stocks are essentially 50-year instruments here in terms of the cash flows that are relevant to their valuation. There are a lot of factors and quiet math that affect the P/E multiple that can be appropriately applied to earnings. Slapping an arbitrary multiple onto elevated earnings reflecting extraordinarily inflated profit margins ignores all of it.”

Montier chimes in with his article What Goes Up Must Come Down:

“Clearly the fi rst two elements of Exhibit 2 are all about cyclical adjustment: we are assuming that the market goes to a “normal” P/E based on “normal” E. Therefore, it is no surprise that we see the same point from a different perspective when we look at a comparison of the simple trailing P/E using the Graham and Dodd P/E (Exhibit 3). The latter tries to smooth out the business cycle’s impact upon earnings by using a 10-year moving average of earnings. Hence, differences between the two measures are a statement of how far earnings are from their “trend.” The simple trailing P/E is around 15x and the Graham and Dodd P/E is around 24x, again highlighting the divergence of profits from their long-run normal levels.”

“To further highlight this dependence of profits upon the fiscal deficit, Exhibit 6 shows the breakdown of profits during 2011. The massive impact that the fiscal deficit has had becomes immediately clear. Government savings have a negative effect on profits; a fiscal deficit is just negative government savings, hence the double minus sign in the table below.”...MORE

In January 2012 Goldman said "Profit Margins Have Peaked".
They were early 
In February 2012 it was Brown Brothers Harriman: "Yes, Profit Margins are Rolling Over (SPY)".
Ditto on the timing.
This is one of the more interesting conundrums in finance.
And tough to make pronouncements on.