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« Investor Guide to the S&P Negative Outlook on US Debt | Main | Shiller Explains! How to use his Trailing PE Ratio »

April 20, 2011



wsm -- I have no reason to be sarcastic with readers who comment. I wish the best for all and hope they continue to find something valuable.

I certainly don't expect everyone to agree with me about everything. That would be a narrow audience! And what would be the point?



@ Lib -

Thanks for your broad over-generalization re: the 'psyche of the general public'.

Despite being a member of said general public, I have participated in the equity market rally. Interestingly, I happen to understand exactly why the market is up (hence why I remain invested).

Hint: it is NOT a reflection of underlying fundamentals. I am agnostic as to what the particular driver of the market is. But when the fundamentals of the domestic economy do begin to influence the market, I will establish my short positions. Until then, long and strong.

Finally, I do not follow politics closely, and therefore do not have much of an opinion on Obama one way or the other. I especially do not consider politics in my investment decisions.


As far as the conclusions I am reaching, I have commented in this space before that I often (over 50% of the time) disagree with the conclusions you come to given the data in your posts.

I read your recent piece on the 'rapid pace of new job openings'. In it, you discount the importance of looking at the net change, and suggest that the absolute additions are impressive (or at least more impressive than the general consensus). I disagree - I think the net change is important. You also suggest that 'only' a 10% change in job openings would get us to the oft-cited 350k monthly jobs amount. I have a problem with how casually you throw out that 10% figure, as if it is realistic in this environment.

I appreciate your request for data regarding the poor quality of jobs currently available. I am working on this. Right now, my only evidence is anecdotal and common sense. I hope to have more soon.

Thanks for your concern (sarcastic or genuine) for my personal wealth. I have been near fully invested in equities over the past year and have managed to make some pretty good money. I recognize that equity markets often act in divergence with economic fundamentals - sometimes for long periods of time. Thus while I could be considered a 'bear' on the domestic economy (if you insist on such labels), that has not kept me from participating in this psychology-driven equity market rally.


Tom -- You and I both read many analyst reports on individual stocks. Analysts each have a model for doing earnings forecasts. In my experience, these models include assumptions about margins, and the assumptions are often quite tough.

The 'top down' strategists are the ones using generalizations. The average talking head is just quoting someone else, with no independent research.

Those discussing profit margins -- and margins alone -- are not considering all of the factors. Individual analysts do.

That is why using one-year forward earnings is valuable.

To be clear -- I agree with your points, but I am taking the opportunity to elaborate a bit.



tom brakke

Late to the debate here, but I think that the main takeaway is that analysts, strategists, and commentators need to be specific about what they foresee.

How often do we hear strategists throw out an S&P earnings number or target level without really decomposing how we will get there?

Or, on a stock level, how fundamentals will contribute to the EPS forecast or target price that's thrown out?

While margins aren't the only factor, they are one of the most important, and one that often gets extrapolated into the future.

It's critical to gauge the sensitivity to margin changes and to assess the probabilities that they will change--just as it's necessary to understand the interplay with other factors and the priority of concerns at any point in time.

With profit margins generally high on an historic basis, it's important to have a view as to why they are "justifiably high" or "unsustainably high." There is not enough of that exposition in much of the work that I see.

Liberal Roman

wsm captures the psyche of the general public. This really has been the most hated really and economic recovery of all time. Half the public geniunely WANTS to see this economy and by association this President fail. They don't understand why the market is up. So, in their wisdom they just blame conspiracy theories. (Absolutely no difference between them and Ancient Greeks blaming thunderstorms on Zeus' wrath)

They don't this rally and they definitely don't want to understand this rally. Obama sucks. Economy must suck. Everything is a conspiracy theory. That is the beginning and end of their logic.


Jeff -- It is interesting. I have seen some similar studies, and you are right. The relationship between expected inflation and interest rates means that either method generates a similar result.

Your table is helpful for anyone waiting for a return of single-digit P/E ratios!

Thanks for sharing this with us.



wsm - If you really read "blogs like this one" you would be reaching different conclusions. I have recently written articles showing a rapid pace in new job openings and demonstrating that a 10% chance in job creation is all that we need to rapidly close the gap.

Your statement about the quality of new jobs is not supported by data. Average hourly wages have increased in line with inflation. Not good, but also not what you suggest.

And please understand -- I am not going to try to "refute" complex arguments in the comment section. I am happy to have people disagree, including people that are firmly persuaded to stay bearish forever. I am not going to repeat the many articles that discuss various ways of measuring and studying earnings, but if you go back and read some of them, it will be helpful to your personal wealth.

Meanwhile, I welcome your comments, and I agree with you about the miserable state of housing. Maybe not all of my mean reversion predictions will be true this year.

I hope you will keep reading, and keep commenting.



Jeff M,

I agree with your points and your methodology.

Thanks for the link to your prior article -- I love your Interest Rates & P/E chart there.
I use a multifactor model in my Overall Market Meter determination and 'Expected vs. Actual P/E' is one of the 9 metrics used (see below). I think I got it from Goldman Sachs; but the concept is similar to your chart, except it uses current inflation instead of your 10-year T-Bond rates. Note: At the current 12-months PCE inflation of 1.6%, the 'expected P/E' from the table below would be 17, which is somewhat higher than the current market P/E (which is in the 14-15 range).

(12 Mos PCE) Expected P/E
<0% 9.0
0.0% to 0.5% 11.0
0.5% to 1.0% 14.0
1.0% to 2.0% 17.0
2.0% to 3.0% 19.0
3.0% to 4.0% 16.0
4.0% to 5.0% 14.0
5.0% to 6.0% 12.0
6.0% to 7.0% 10.0
> 7.0% 8.0

Hope you find this info interesting and useful.

Jeff P


Greg -- I agree that the growth of earnings (margins and revenues) is a little different for each company. I'm sure that we both look for stocks with earnings growth and good valuations.

So most of the world, even people who share our approach, abandon this careful discipline and look only at mean reversion in profit margins, ignoring part of the story.

Surely it must be better to make an attempt at the analysis you describe. Fortunately, we have hundreds of analysts doing this work for us. Every research report we read on every company discusses these factors. Moreover, I have demonstrated that the one-year forecast by analysts is the best method of earnings estimation. I continue to invite anyone to present data to the contrary.

To summarize, I agree with your approach, and I appreciate your taking the time for a thoughtful comment. I hope I have explained the best way to compare the variables for the market as a whole.


Greg Feirman

"At the end of the day I don't care that much about profit margins, I care about profits....growing huge...." - James Altucher

I think it's fair to say that that is the main argument of your post.

If margins are in fact headed lower, then how is that we get profit growth? If less of every dollar on the top line is going to the bottom line, how do does the bottom line grow?

Only one way: REVENUE GROWTH.

In order for earnings to keep growing as margins compress, revenue growth has to more than make up for margin compression.

One commenter suggests that a 10% decrease in margins is offset by a 10% increase in revenue. This may or may not be correct depending on the meaning.

If revenues are $1 million with a net margin of 20%, profits are $200,000. A 10% increase to $1.1 million and a 10% decrease in net margin to 10% would result in a 45% decrease in profit to $110,000.

However, if it is meant that margins will decrease 10% from 20% to 18%, profit will remain relatively constant.

In this scenario, 10% top line growth and a 2% decrease in net margin results in constant profits. If net margin declines 1% to 19%, profit would be 209,000 or 4.5% growth.

My point is that you need a lot of revenue growth to make up for a little margin erosion.

Greg Feirman
Top Gun Financial


*meant to contrast STRUCTURAL global employment dynamics with CYCLICAL (not structural) domestic dynamics


I try to stay away from financial infotainment TV. Most of my sources are blogs like this. It is fair to say that skepticism is higher the last 5 years than the previous 5. I thought you were talking more short-term (~2-3 months).

As far as employment, I do not see any evidence for employment reverting to historical means (say, of the past 20 years). While we should get a nominal bounce-back in jobs, those jobs have been lower-paying (or fewer hours), on average, than the previous position someone held. Furthermore, in order to even begin replacing the jobs that were lost in the past 5 years, we would need to see a MAMMOTH recovery, not the piddling recovery that is somehow embraced by today's bulls. But many of those jobs are never coming back - ever. It is a structural reality driven by global wage migration, not a structural domestic issue.

Combine this with the horrific dynamics in housing (which you did not refute), and current valuation levels (especially on 'as-reported', i.e. ex-bad stuff, EPS) simply ignore a large chunk or reality.


wsm - My article on things being more normal was designed to highlight many extremes that we have reached in the great recession and the rebound. Unlike the laundry lists of unquantified "headwinds" that I regularly criticize, mean-reverting behavior is extremely well-established as a basis for predictions. In addition, it can be quantified, at least to the point of making estimates. Revenue growth was almost zero, for example, and could be expected to return to the long-term trend. The same for employment.

I did not suggest that declining margins improve employment. I think it is fair to note that companies squeezed extra productivity out of existing workers, and will need to do some hiring. Doesn't that make sense to you?

And finally, if you do not see any skepticism, you have an interesting list of sources. Individual investors have been pulling money out of stocks over the last five years. Trader types think the market rally is all fluff, not earnings based. There is a daily litany of world problems reported on financial TV.

We are well stocked with widely known worries!

Thanks for weighing in.



Jeff - You are correct in noting that the pace of various changes makes a difference. That is looking at the problem the right way, instead of focusing just on margin compression.

As to multiples, I have done fairly exhaustive research on this. The multiple is unduly low when interest rates are extremely low, probably because everyone is worried about the economy and deflation. Profit expectations get no respect. You can start with this article

and follow the links for a comprehensive answer.

Thanks for the good question.



"Many other factors are at work. As margins narrow, employment will rise, revenue will rise, housing will stabilize, skepticism will decrease, P/E multiples will improve and stocks will rise."

Do you have any evidence of this, or are you merely throwing it out there, like the 'skeptics'laundry list you attempt to defame? (I actually agree with the majority of the list - they are all valid questions that need to be asked, and answered, before placing faith in reported EPS results).

For instance, why is margins narrowing a catalyst for increasing employment? That makes no sense to me.

Also, have you looked at any housing data lately? What gives you any indication that 'housing will stabilize'?

Finally, how do you figure that 'skepticism will decrease'. I don't see how it could go any lower than the current environment.


Some good points. But are you saying that when margins compress and revenues rise, P/Es will also rise? If margins compress 10% while revs rise 10%, then don't earnings $s remain stable? What causes P/Es to rise under this scenario? P/Es are now around 14, slightly below their historical average. What is your expectation of where they will be a year from now? Two years from now?
Thanks, in advance, for your reply.


I completley agree, that is one argument I have with some of my bearish friends that the path of margin compression doesn't have to be rapid. It could revert to the mean over 5 years and in the meantime revenue could climb such that we still have a growing level of earnings.
But I do think that due to high margins the rate of growth of earnings will be slower after this year. So going forward we will need PE expansion to get stronger moves up in the market.

romanya vizesi

thank you very much for information

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