The key takeaway is that “GMO are firm believers in mean reversion; such record elevation in profit margins causes us much consternation.”
All charts and commentary below via Montier:
Currently, U.S. profit margins are at record highs according to the NIPA data (see Exhibit 1). More freakish still is that these record high profit margins are coming during the weakest economic recovery in post-war history:
Exhibit 2 shows that in simple trailing P/E terms the U.S. market isn’t actually expensive. However, the P/E is only one part of a valuation – it also depends upon the state of earnings. It is the margin component that is dragging our return forecast down. If we are incorrect on our assumption of mean reversion in profit margins, then our forecast radically alters. For instance, if instead of falling to 6% over the next 7 years margins stayed at today’s levels, our forecast would be closer to 4.5% p.a.:
Clearly the first 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 profi ts from their long-run normal levels.:
Whilst we at GMO fret over evidence of the strained nature of profit margins, the ever bullish Wall Street analysts expect profit margins to continue to rise! Witness Exhibit 4. In our search for evidence of a structural break, this simple-minded extrapolation gives us some comfort because the Wall Street consensus has a pretty good record of being completely and utterly wrong:
What Goes Up Must Come Down!
GMO White Paper, March 2012 http://bit.ly/GTKDwI