Yo! A Harbinger of Doom or the Future?

For the last few weeks I’ve been inundated with news stories in my Twitter feed about a new app, Yo. I like to be on the cutting edge of technology and finally gave in a clicked on a story about this amazing app. What I found both amused and frightened me. I can sum of the app succinctly, with a single touch you can send someone the word “Yo.” Stephen Colbert does a great job explaining this stunning new technology:

As underwhelming as this concept sounds, the company is being heralded as the future by some, including a columnist for Forbes who says:

Forbes’s Anthony Wing Kosner believes the app has huge potential. “If a ‘Yo’ could also contain a link, the impact would be huge” Kosner says.

He adds: “Consider the meaning of a ‘yo’ with a map location, with a web address, with a song or a YouTube video? The ability to shout out the immediate context is what Twitter is supposed to be for, but who wants to bother crafting 140 characters anymore?”

Read more: http://www.theweek.co.uk/technology/59094/yo-app-what-is-it-and-why-is-it-popular#ixzz36jeZGyB6

While not huge, the company has raised $1 million to further develop the app.

In my opinion Yo is among the dumbest things I’ve heard since the height of the last tech bubble, anyone remember Pets.com (by the way, pets.com wasn’t actually a terrible idea)? If Yo is a proxy for the caliber of company getting funded today, we are in trouble. Tech Boom 2.0 will surely end in Tech Bust 2.0.

I do think that this tech boom is different, but it has parallels to the last one (Uber with an $18 billion valuation?). There is no doubt that there are legit companies creating real value and that I have no doubt will be around a decade from now, but it does feel like we are hitting the froth stage of this market. With that said, the froth stage can last longer than anyone thinks (remember the relentless tech stocks of the late nineties?).

Yo is most certainly a fad and a company that will not be around (at least in its present form) in a few years, but does Yo represent the beginning of the end of this second great tech boom?

Only time will tell and I’m not rooting for any bust in tech – it’s my favorite pastime!

Scott Dauenhauer, CFP, MPAS, AIF

 

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This Week In Confirmation Bias: Overvaluation Continues

I like to think that I can remain an objective observer, but we all have our biases. My research leads me to believe that stocks are overvalued right now (and not by a small amount). Confirmation Bias is when we purposely pursue theories that confirm our beliefs and ignore ones that don’t. In that vein, I’m going to post some data that supports my belief…acknowledging that while I think there is good reason to trust the data, it could just be pure confirmation bias.

Douglas Short over at Advisor Perspectives blog has a monthly post where he highlights Market Valuation, here is his current post:

Note from dshort: I’ve tweaked this commentary to include today’s Federal Reserve release of the Z.1 Financial Accounts for Q1.


Here is a summary of the four market valuation indicators I updated at the beginning of the month.

  • The Crestmont Research P/E Ratio (more)
  • The cyclical P/E ratio using the trailing 10-year earnings as the divisor (more)
  • The Q Ratio, which is the total price of the market divided by its replacement cost (more)
  • The relationship of the S&P Composite price to a regression trendline (more)

To facilitate comparisons, I’ve adjusted the two P/E ratios and Q Ratio to their arithmetic means and the inflation-adjusted S&P Composite to its exponential regression. Thus the percentages on the vertical axis show the over/undervaluation as a percent above mean value, which I’m using as a surrogate for fair value. Based on the latest S&P 500 monthly data, the market is overvalued somewhere in the range of 51% to 85%, depending on the indicator, up from the previous month’s 50% to 83%.

I’ve plotted the S&P regression data as an area chart type rather than a line to make the comparisons a bit easier to read. It also reinforces the difference between the line charts — which are simple ratios — and the regression series, which measures the distance from an exponential regression on a log chart.

The chart below differs from the one above in that the two valuation ratios (P/E and Q) are adjusted to their geometric mean rather than their arithmetic mean (which is what most people think of as the “average”). The geometric mean weights the central tendency of a series of numbers, thus calling attention to outliers. In my view, the first chart does a satisfactory job of illustrating these four approaches to market valuation, but I’ve included the geometric variant as an interesting alternative view for the two P/Es and Q. In this chart the range of overvaluation would be in the range of 63% to 99%, up from last month’s 62% to 97%.

The Average of the Four Valuation Indicators

The next chart gives a simplified summary of valuations by plotting the average of the four arithmetic series (the first chart above) along with the standard deviations above and below the mean.

At the end of last month, the average of the four exceeded the credit bubble peak preceding the last recession.

Here is the same chart, this time with the geometric mean and deviations. The latest value of 80% is not far below the two standard deviation value of 82%.

As I’ve frequently pointed out, these indicators aren’t useful as short-term signals of market direction. Periods of over- and under-valuation can last for many years. But they can play a role in framing longer-term expectations of investment returns. At present market overvaluation continues to suggest a cautious long-term outlook and guarded expectations. However, at the today’s low annualized inflation rate and the extremely poor return on fixed income investments (Treasuries, CDs, etc.) the appeal of equities, despite overvaluation risk, is not surprising. For more on that topic, see my periodic update: Market Valuation, Inflation and Treasury Yields: Clues from the Past

In another post tracking the Buffet Valuation indicator, Short posts the following:

Market Cap to GDP is a long-term valuation indicator that has become popular in recent years, thanks to Warren Buffett. Back in 2001 he remarked in a Fortune Magazine interview that “it is probably the best single measure of where valuations stand at any given moment.”

The four valuation indicators I track in my monthly valuation overview offer a long-term perspective of well over a century. The raw data for the “Buffett indicator” only goes back as far as the middle of the 20th century. Quarterly GDP dates from 1947, and the Fed’s B.102 Balance sheet has quarterly updates beginning in Q4 1951. With an acknowledgement of this abbreviated timeframe, let’s take a look at the plain vanilla quarterly ratio with no effort to interpolate monthly data or extrapolate since the end of the most recent quarterly numbers.

The strange numerator in the chart title, MVEONWMVBSNNCB, is the FRED designation for Line 36 in the B.102 balance sheet (Market Value of Equities Outstanding), available on the Federal Reserve website. Here is a link to a FRED version of the chart. Incidentally, the numerator is the same series used for a simple calculation of the Q Ratio valuation indicator.

The “market cap” numerator was updated today through Q1.

For version that’s current through Q1, I can offer a more transparent alternate snapshot over a shorter timeframe. Here is the Wilshire 5000 Full Cap Price Index divided by GDP. I’ve used the FRED data for the stock index numerator (WILL5000PRFC).

A quick technical note: To match the quarterly intervals of GDP, for the Wilshire data I’ve used the quarterly average of daily closes rather than quarterly closes (slightly smoothing the volatility).

What Do These Charts Tell Us?

In a CNBC interview earlier this spring CNBC interview (April 23rd), Warren Buffett expressed his view that stocks aren’t “too frothy”. However, both the “Buffett Index” and the Wilshire 5000 variant suggest that today’s market is indeed at lofty valuations, now above the housing-bubble peak in 2007. In fact, the more timely of the two (Wilshire / GDP) has risen for eight consecutive quarters and is now approaching two standard deviations above its mean — a level exceeded for six quarters during the dot.com bubble.

For good measure, I’ll throw in John Hussman’s weekly Commentary “We Learn From History That We Do Not Learn From History.”

Enjoy.

Scott Dauenhauer, CFP, MPAS, AIF

 

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Katsenelson: The Modern Portfolio Theory Flat Earth Society

Flat EarthI like reading Vitaliy Katsenelson’s work. Though I don’t always agree, he’s a unique author among the many who call themselves so in the industry. Seeing the title of his latest piece, I was immediately drawn to it.

Excerpts from Katsenelson’s May 14th Article titled:

The Modern Portfolio Theory Flat Earth Society

“I’d rather be vaguely right than precisely wrong.” That’s my favorite quote from British economist John Maynard Keynes; it took me a long time to truly appreciate its importance. Math and physics are rooted in equations that spit out precise answers; vagueness there is dangerous — for the right reasons. That is why they are called exact sciences. Investing, despite being taught as an almost exact science, is far from it. It is a craft that falls somewhere between art and science.

The opening paragraph represents a view that is not on display in the financial services industry. The industry would like you to believe that the world of finance can easily be described by equations, this thinking led to the financial crisis. At the heart of many of these equations is a number we know as “beta.”

A few months ago, while analyzing a company, I asked an executive of a Fortune 500 company what his company’s cost of capital was. The answer I got was, “Well, the beta of our stock is 0.6, and our cost of debt is 3.25 percent, so the cost of capital is 6.35 percent.” Warren Buffett was asked about Berkshire Hathaway’s cost of capital at his recent annual meeting. The Berkshire CEO’s answer was vague — “It is what can be produced by our second-best idea” — but it was right.

I am often asked by students if I recommend studying for the Chartered Financial Analyst designation. In the past I always responded with an unequivocal yes. There were many reasons for that: The CFA charter is like getting a master’s degree in finance and investing at a fraction of the cost, and it is valued just as much. Employers like it because it is standardized, and they know what you had to learn. The CFA covers a lot of material, from ethics to financial derivatives.

I once thought the exact same way, until the financial crisis happened and until I spent six months immersed in the course work.

Lately, however, I have found myself qualifying my yes answer. If you are looking to do the CFA for self-education, I wouldn’t bother. The reason for that is simple: The CFA curriculum spends too much time on Modern Portfolio Theory (MPT). That is the nonsensical set of formulas used by the Fortune 500 executive to compute his company’s cost of capital. (I have to qualify this: I finished my CFA in 2000. Maybe the CFA curriculum has changed since then.)

I studied for it in the very recent past, it hasn’t changed and in fact has moved further down the MPT road.

MPT — a Noble Prize–winning theory — has lots of flaws. Beta, a mostly random number, is sitting right in the middle of the calculation of MPT. The theory assumes investors are rational — no, that is not a typo. If you are not laughing, you should be: A recent study by Boston-based research firm Dalbar found that the average (rational) investor in U.S. stock mutual funds received an annual return of 3.7 percent during the past 30 years, significantly underperforming the funds in which they invested (they bought high and sold low), as well as the S&P 500 index, which returned 11.1 percent a year during that period. MPT defines risk as volatility, whereas rational people would say that permanent loss of capital is the real risk.

MPT is a great equation, it just doesn’t work. I would take issue with the use of the Dalbar study, I’m not sure it’s as accurate as many think.

These are not all the flaws, but it would take too much time to go through them. The central flaw of MPT, though, is that it’s a theory with few practical implications. This analytical portfolio framework is used not by analysts or portfolio managers but only by academics and an army of consultants (neither group invests for a living). In other words, by studying MPT your brain cells have died for nothing.

I would argue the opposite, this theory is used by many in the money management industry, especially many of the so-called Robo-Advisors (who tout it as the engine of their models).

Imagine you are living in the Dark Ages and the Greeks already proved that the world is round, but the world-is-a-ball theory is not being widely taught. So teachers, who rarely step outside the walls of their own institutions, confidently declare to their students that the world is flat, whereas those who meanwhile roam this wonderful planet more widely (let’s call them entrepreneurs and investors) know perfectly well that it is round. This is pretty much what is happening today with the divide between real-world and academic investment professionals.

Correct, except many real-world professionals also adhere to this theory religiously. They worship at the alter of MPT and efficient markets.

If you learn anything by going to the Berkshire Hathaway annual meeting, it is the incredible power of incentives. Berkshire vice chairman Charlie Munger is big on that idea. Teachers will teach what is teachable; they’ll default to solving a mathematical equation (while stuffing it with arbitrary numbers for the most part), because that is what they know how to do. They can learn MPT by reading their predecessors’ textbooks, and therefore that is what they’ll teach, too. The beauty of MPT, at least from a teaching perspective, is that it turns investing into a math problem, with elegant equations that always spit out precise, albeit random numbers.

But please don’t tell anyone I said this, because as an investor I’d love for MPT to be taught starting in kindergarten. It would make my job easier: I’d be competing against imbeciles who still believe the world is flat. However, as a well-wishing person dispensing advice, I’d say, spend as little time as you can studying MPT.

I was indoctrinated into MPT early in my financial services education and am still trying to extricate myself!

You can read the entire post here.

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Lance Roberts: It’s Only Like This, Until It’s Like That

It’s Only Like This, Until It’s Like That

Lance Roberts
Tuesday, 29 April 2014

This morning I received a blog written by Brad DeLong which asked a simple question; why are people depressed about medium-term prospects for equity investments? He claims he doesn’t understand the gloomy mindset. However, the evidence contradicts DeLong’s underlying assumption about investor attitudes. And when we dig deeper, we find that history doesn’t support his assumption about future market returns.

The title of his post suggests that MANY individuals are depressed about future equity returns which would suggest that investors are bearish and are hoarding cash. However, this is hardly the case when the majority of investors are fully invested and leveraged as shown in the two charts below.

AAII-Asset-Allocation-041614

 

MarginDebt-NetCredit-040814-2

There are only a few people, besides myself, that discuss the probabilities of lower returns over the next decade.  Henry Blodget, the focus of the DeLong’s post, Jeremy GranthamDoug ShortCrestmont Research and John Hussman are the most notable.

Let’s jump into Brad’s math.  He states:

“I see that stocks are likely to return:

  • 6%/year in real (inflation adjusted) terms,
  • plus or minus whatever changes we see in valuation ratios.

That means that if we expect to see P/E10 fall over the next decade from 25X to 19X then we can expect to see returns of 3%/year real–that is, 5%/year nominal. That means that if we expect to see P/E10 fall all the way back to 15X over the next decade, then we can expect to see returns of 1%/year real–that is 3%/year nominal. But that is unlikely to happen. And if P/E10 remains at its current valuation ratios, we have 6%/year real returns–8%/year nominal.

Equities still look very attractive to me…”

First, he makes the assumption that stocks will compound at 6% per year, every year, going forward.  This is a common mistake that is made in return analysis. Equities do not compound at a stagnant rate of growth but rather experience a rather high degree of volatility over time.

The chart below shows the S&P 500 as compared to annualized returns and the average of market returns since 1900.  Over the last 113 years, the market has NEVER had a 6% return. The two closest years were 6.94% in 1993 and 5.24% in 2005. If we give it a range of 5-7%, it brings the number of occurrences to a whopping three.

Assuming that markets have a set return each year, as you could expect from a bond, is grossly flawed. While there are many years that far exceeded the average of 6%, there are also many that haven’t. But then again, this is why 6% is the “average” and NOT the“rule.”

 Sp500-AnnualReturns-042914

Secondly, and more importantly, the math on forward return expectations, given current valuation levels, does not hold up.  Brad assumes that valuations can fall without the price of the markets being negatively impacted.  History suggests, as shown in the next chart, that valuations do not fall without investment returns being negatively impacted to a large degree.

SP500-PE-042914

Furthermore, John Hussman recently did the “math” in this regard showing this to be true.

“Let’s assume that despite the weak economic growth at present, nominal GDP picks back up to a nominal growth rate of 6.3% annually from here. This may be overly optimistic, but near market peaks, optimistic assumptions often still result in troubling conclusions. Given the present market cap / GDP ratio of 1.25 and an S&P 500 dividend yield of just 2%, what might we estimate for total returns over the coming decade?

(1.063)(0.63/1.25)^(1/10) – 1.0 + .02 = 1.3% annually.

Since we use a whole range of additional measures, including earnings-based methods, to estimate prospective returns, our actual estimates are somewhat higher here, at about 2.4% annually over the coming decade. Tomato. Tom-ah-to. Keep in mind that these estimates assume a significant acceleration in economic growth. One can certainly quibble that the long-term ratio of market capitalization to GDP will have a somewhat higher norm in the future. But the present ratio is still 100% above its pre-bubble norm. It’s unlikely that this situation will end well.

The chart below shows the record of these estimates since 1949, along with the actual 10-year S&P 500 total returns that have followed.”

Hussman-042914

As the Buddha taught, “This is like this, because that is like that.” Extraordinary long-term market returns come from somewhere. They originate in conditions of undervaluation, as in 1950 and 1982. Dismal long-term returns also come from somewhere – they originate in conditions of severe overvaluation. Today, as in 2000, and as in 2007, we are at a point where “this” is like this. So “that” can be expected to be like that.”

Nominal GDP growth is likely to be far weaker over the next decade.  This will be due to the structural change in employment, rising productivity which suppresses real wage growth, still overly leveraged household balance sheets which reduces consumptive capabilities and the current demographic trends.

Therefore, if we assume a 4% nominal economic growth, the forward returns get much worse at -5.2%.

Brad is an extremely smart economist. However, the analysis makes some sweeping assumptions that are unlikely to play out in the future. The market is extremely volatile which exacerbates the behavioral impact on forward returns to investors. (This is something that is always “forgotten” in most mainstream analysis.)  When large market declines occur within a given cycle, and they always do, investors panic sell at the bottom.

The most recent Dalbar Study of investor behavior shows this to be the case.  Since the inception of the study (1984), the S&P 500 has had an average return of 11.11% while equity fund investors had a return of just 3.69%.  This has much to do with the simple fact that investors chase returns, buy high, sell low and chase ethereal benchmarks. (Read“Why You Can’t Beat The Index”The reason that individuals are plagued by these emotional behaviors, such as “buy high and sell low,” is due to well-meaning articles espousing stock ownership at cyclical valuation peaks.

As I stated previously, the current cyclical bull market is not likely over as of yet. Momentum driven markets are hard to kill in the latter stages particularly as exuberance builds.  However, they do eventually end. That is unless Brad has figured out a way to repeal economic and business cycles altogether.  As we enter into the sixth year of economic expansion we are likely closer to the next contraction than not.  This is particularly the case as the Federal Reserve continues to extract its financial supports in the face of weak economic underpinnings.

Will the market likely be higher a decade from now?  A case can certainly be made in that regard.  However, if interest rates or inflation rises sharply, the economy cycles through normal recessionary cycles, or if Jack Bogle is right - then things could be much more disappointing. As Seth Klarman from Baupost Capital recently stated:

“Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”

We saw much of the same analysis as Brad’s at the peak of the markets in 1999 and 2007. New valuation metrics, IPO’s of negligible companies, valuation dismissals as “this time was different,” and a building exuberance were all common themes. Unfortunately, the outcomes were always the same. It is likely that this time is “not different” and while it may seem for a while that Brad analysis is correct, it is “only like this, until it is like that.”

You can access the original blogpost here

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Short Takes Blog: The Two Most Important Questions For Investors

Ciovacco Capital Management, LLC (CCM) has a blog called Short Takes which offered an interesting piece lately that I think is important, asking what are “The Two Most Important Questions For Investors?

The piece caught my eye because it echoed my last quarterly commentary and my current view, here are some excerpts from the post.

Many investors toss and turn at night worrying about wealth-destroying bear markets or opportunities they may miss for their uninvested cash, which is nature’s way of pointing out vulnerabilities. When testing your current approach to the markets, it is helpful to look at extreme outcomes. If you can handle the extremes, then you can handle almost anything in between. Therefore, this weekend ask yourself:

Do I have specific plans in place to handle these extreme investment cases?

Case A: stocks rise an additional 91% over the next three years as they did during the final leg of the dot-com bubble (1997-2000).

Case B: stocks drop over 50% as they did in the 2000-2002 and 2007-2009 bear markets.

Of course we might be in a market that ends differently than these two cases (such as a flat market for years to come), but given the current valuation levels relative to history, there is evidence to the contrary. Here is what CCM says:

How could stocks possibly rise 91% between 2014 and 2016 with valuations already stretched? That is a rational question and one that was being asked in 1997. From a contingency planning perspective, it is best to always keep an open mind about upside and downside potential. The S&P 500’s recent breakout from a 13-year consolidation pattern, described here, is another reason to keep an open mind about hard-to-comprehend gains.

CCM CaseASmallForPost

During a bear market, investors start to believe that stocks will never go up again. Conversely, the longer a bull market lasts, the harder it is to comprehend that a bear market will come at some point. When the next bear market begins is highly uncertain, but we know with 100% certainty that another bear market will eventually rear its ugly head. If we know a bear market is in our investment future, it is prudent to have specific plans in place.

CCM II CaseBFEB212014

CCM goes on to show how either the gain or loss would affect your portfolio:

CCM III TableLossForPostSmallB

CCM IV TableLossForPostSmallA

 

CCM goes on to use some technical analysis to determine how best to position yourself, but I think the above to charts are the important ones. Is missing out on a portion of the potential upside a better outcome than experiencing a substantial portion of the downside? This is the question that should be primary in your thought process right now.

Scott Dauenhauer, CFP, MPAS, AIF

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Roberts: It’s Impossible To Replay The 90′s

Written by Lance Roberts | Monday, March 24, 2014

There was a very interesting article out this morning on Bloomberg discussing “Is The Stock Market About To Go Totally 90′s?”  The opening paragraph is as follows:

“Early in 1992, Time magazine projected that the nascent economic recovery would be ‘one of the slowest in history and the next decade one of lowered expectations.’ That was the conventional wisdom and, at the time, seemed eminently reasonable. It also turned out to be completely wrong. The Internet and huge productivity gains propelled above-average economic growth and a rip-roaring, “Cult of Equity” bull market that surged into the year 2000. We spent and borrowed like mad and eased into fluffy college majors.”

There are a couple of issues with this statement worth discussing.

To start with, Time Magazine was not entirely wrong.  The chart below shows the annual percentage change in real economic growth from 1854-present.  I have marked both the zero percent growth rate line and the average rate of real economic growth which is 3.56% historically.

While Time Magazine was early in the sub-par growth rate call for a couple of years, it eventually did come to pass through the entirety of the 21st century, so far. While the internet boom did cause an increase in productivity, it also had a very deleterious effect on the economy. As I discussed recently in “50% Profit Growth:”

“Since 2000, each dollar of gross sales has been increased into more than $1 in operating and reported profits through financial engineering and cost suppression. The next chart shows that the surge in corporate profitability in recent years is a result of a consistent reduction of both employment and wage growth. This has been achieved by increases in productivity, technology and offshoring of labor. However, it is important to note that benefits from such actions are finite.”

This drive to increase profitability did not lead to increased economic growth due to increased productive investment and higher savings rates as personal wealth increased. The reality was, in fact, quite the opposite as it resembled more of a “reverse robin-hood effect” as corporate greed and monetary policy led to a massive wealth transfer from the poor to the rich.

It is easy to understand the confusion the writer has from just looking at the stock market as a determinant of economic prosperity. Unfortunately, what was masked was the deterioration of prosperity as debt supplanted the lack of personal wage growth and a rising cost of living.

The chart below shows the rise in personal debt, which was fostered by 30 years declining borrowing costs, to offset the declines in personal income and savings rates.

As the author correctly states above, it was the “borrowing and spending like mad” that provided a false sense of economic prosperity. The problem with this assumption is clearly shown in the chart below.

In the 1980′s and 90′s consumption, as a percentage of the economy, grew from roughly 61% to 68% currently. The increase in consumption was largely built upon a falling interest rate environment, lower borrowing costs, and relaxation of lending standards.

In 1980, household credit market debt stood at $1.3 Trillion. To move consumption, as a percent of the economy, from 61% to 67% by the year 2000 it required an increase of $5.6 Trillion in debt. Since 2000, consumption as a percent of the economy has risen by 1% over the last 13 years. In order to support that increase in consumption it required an increase in personal debt of $6.1 Trillion.

The importance of that statement should not be dismissed. It has required more debt to increase consumption by 1% of the economy since 2000 than it did to increase it by 6% from 1980-2000.

The problem is quite clear. With interest rates already at historic lows, consumers already heavily leveraged and economic growth running at sub-par rates – there is not likely a capability to increase consumption as a percent of the economy to levels that would replicate the economic growth rates of the past.

It is quite apparent that the ongoing interventions by the Federal Reserve has certainly boosted asset prices higher. This has further widened the wealth gap between the top 10% of individuals that have dollars invested in the financial markets, and everyone else. However, while increased productivity, stock buybacks, and accounting gimmicks can certainly maintain an illusion of corporate profitability in the near term, the real economy remains very subject to actual economic activity. It is here that the inability to releverage balance sheets, to any great degree, to support consumption provides an inherent long term headwind to economic prosperity.

In my opinion it is likely quite impossible, from an economic perspective, to replay the secular bull market of the 80-90′s. While I would certainly welcome such an environment, the more likely scenario is a repeat of the 1970′s. The trick will be remaining solvent for when the next secular bull market does indeed eventually arrive.

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Opposing Views on Profit Margins: Roberts vs Philosophical Econ

There is quite a debate going on in the world of economics in regards to profit margins. On one side of the debate we have those who believe that elevated profit margins are unsustainable and on the other side we have those who believe that not only are they sustainable, they can go higher. It’s important because most of our assumptions that make up our expected returns are in some form or fashion based on profit margins.

A basic law of economics…or logic for that matter is that in a functioning economy excess profits bring competition. If I create a company and it is able to make excess profits, it will attract competition, which will likely compress those excess profits. I’m not the only one who thinks this, those who are considered legend do as well:

Warren Buffett, 1999

[F]rom 1951 on, the percentage settled down pretty much to a 4% to 6.5% range.

In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well.

– Warren Buffett, Mr. Buffett on the Stock Market (November 1999)

Jeremy Grantham, 2006

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, Barron’s (c. 2006), via Katsenelson, The Little Book of Sideways Markets.

This brings us to the present day debate which I present from the blog Philosophical Economics (PE) and the blog run by Lance Roberts at STA Wealth Management. The PE blog is the one that irks me the most, but not for the reason you may think. While every fiber of my being wants to disagree with the ideas presented (essentially that profit margins are high and will remain so, potentially going higher and thus justifying high valuations) the post is well written and actually corresponds to what Jeremy Grantham is saying above – “If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” I’m not convinced PE blog is wrong because I’m not convinced something isn’t wrong with the system.

With that said, I still find it hard to believe that healthy competition in many markets doesn’t exist and that this should at some point in the a cycle act to lower profit margins.

The two blog posts I’m referring to are as follows:

50% Profit Growth And Historical Realities  (STA Wealth Management)

Profit Margins: The Epicenter of the Valuation Debate (Philosophical Economics)

I’ll likely post both to this blog in their entirety later this week.

Scott Dauenhauer, CFP, MPAS, AIF

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