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« Weighing the Week Ahead: Time for a Turn in Housing? | Main | Weighing the Week Ahead: How Worried Should We Be? »

February 22, 2012

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scm0330

Jeff,

Wesbury is a permabull and terminally infected by his political views. I wince on those occasions where you cite his authority on anything.

On the margin subject, like Assetman above, I'd like to see some discussion about where the margins are coming from - operating numbers, for example, or the tax line. I suspect the tax department at MNCs have been helping to trend margins for the better for many years now, but I'd suggest those aren't high-quality numbers and don't deserve a high capitalization.

I am generally unconvinced of the "it's different this time" arguments offered by the margin bulls. Margins will revert to something lower, it's just a matter of when. It's probable though, absent a recession, that overall profits remain stable, with higher volumes offsetting lower margins.

The Assetman

What might be more relevant to the conversation is to consider what drives corporate profits (revenues, cost of goods, operating leverage, interest/financial leverage, taxes) and whether the tailwinds from these sources have been totally tapped out. In some cases, the answer is "likely", in other cases, the "likely" answer is debatable.

In reality, profit cycles have the ability to last longer than one thinks-- mainly because there are a lot of levers firms can pull to drive things higher in the right conditions (like now). And those that can gain market share at the expense of others (think Apple vs. HPQ), can keep the profit engines going while gaining a greater share of the market cap pie.

Do profits mean revert? Sure-- they revert with the business cycle in aggregate. But because each business cycle is different, the slope of that mean over time can shift as well.

In the 2000-02 recession period, you'd be surprised to discover that the magnitude of economic decline didn't come close to matching the decline in profits, and the resulting multiple compression. One could rationally argue that outsized premiums were being placed in peak profits during that time.

By comparison, the premiums placed on the profits already earned might make this market appear relatively cheap. I don't think it's a stretch to argue, though, that the underlying sources of these profits (save the exceptions of labor/capital utilization) are becoming scarce. If one can reignite that cap utilization fuse, then this discussion on profit cycles reverting anytime soon becomes somewhat moot.

John Lounsbury

Jeff - - -

A week ago Steve Hansen posted an article about the latest PPI data: http://econintersect.com/wordpress/?p=19345

He has been following the decline in PPI over recent months. There are two relevant factors to your discussion:

1. PPI has been declining toward the CPI number. It's still higher (ca. 4%) but was much higher several months ago.

2. The Crude goods PPI has been very much higher than the finished goods number for the past year but has now come down almost to the same level.

These two events are indicating less margin pressure for finished goods producers and should help earnings improve in those sectors.

I am a mean reversion advocate, simply because I do not believe the business cycle has been overturned. However, there are some things happening right now which may mean that the next business cycle dip may not be quite here yet, ECRI's stubborn prediction notwithstanding (and John Hussman and others as well).

I believe your discussion is very timely.

oldprof

Angel -- I have been thinking about this and I have an article on the agenda.

My preliminary conclusion is that the 2000-era recessions were greater and therefore had a bigger effect on earnings forecasts.

A corollary question is whether earnings forecasts should incorporate the chance of a recession. For a one-year period? For a five-year period?

The answer should be different.

Good question and my answer is only preliminary.

Jeff

oldprof

Proteus -- There is merit in your argument. I am trying to look at the most conservative case.

Meanwhile I am finding companies like those you name.

Good points....

Jeff

Angel Martin

Jeff, good article.

I looked at the S&P earnings decline in the last few recessions because I though the 30% decline assumption seemed excessive.

Interestingly, the S&P earnings decline in a recession seem to be getting bigger over time. Earnings fell 10% in 1970, 18% in 1975, 13% peak to trough in 1983,
21% between 1989 and 1991, and 30% in both 2001 and 2006-09.

Jeff, I know inflation was an issue for the numbers from the 1970's but what do you attribute the larger declines in recent years? Higher corp debt levels?

Is this trend just a fluke? Or, does it mean that missing a recession call has a greater downside risk than 20 years ago?

Proteus

Here's my argument for margins not being mean reverting (at least for an individual company). High margins allow the company to hire the best talent, making it unavailable to their competitors. They can demand and get the best product placement for retail sales. Purchase orders go there because of reputation. These companies used to be called monopolies, and they are very hard to break. I might be wrong, but we sure seem to have a bunch of them right now.

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