High Profit Margins and Shiller PE

Robert ShillerBy World Economic Forum from Cologny, Switzerland [CC BY-SA 2.0], via Wikimedia Commons

High Profit Margins and Shiller PE

Dr. Jeff Miller wrote an interesting question the other day:

Why does a Shiller disciple care about profit margins?

Now, I am not a disciple of Dr. Shiller, I disagree with him on many issues, Trills for an example.  When Shiller talks, odds are 50-50 that I agree, which makes him interesting to me, unlike Bernanke and Krugman who I almost always disagree with, and James Grant and Caroline Baum, who I almost always agree with.  Someone who agrees with me and disagrees with me equally is interesting, because he makes me think harder.

And with his cyclically-adjusted price-earnings [CAPE] ratio, I was a reluctant partial convert.  Consider this piece.

There are a couple ways to answer the question:

  1. Most stocks are cheap on a forward P/E basis, less so on a trailing P/E basis, and still less so on a P/B or P/S basis.  The difference between P/E and P/S is profit margin — E/S.
  2. Consider the critiques from Dr. John Hussman, who awaits the reset that will come if/when profit margins get competed down.
  3. My answer: we should care about it a little, for the above reasons.  But labor is no longer scarce, which leads to higher profit margins for a time while wages are depressed.

My view is that profit margins will not revert to mean for many years, until the increase in capitalist labor is absorbed.  Until then economic results will be poor those that labor on the low end — you have got a lot of new competition.

As I wrote earlier:

A reason to consider the validity of the CAPE is twofold: it has a huge similarity to Tobin’s Q-ratio, which compares market capitalization to replacement cost.  It also has a similarity to Michael Alexander’s Price-to-Resources ratio, out of which the book makes a lot (link here for an example).  It’s a Price-to-Adjusted Book value ratio as I see it.

The CAPE has value as a proxy.  It mirrors overall market value pretty well, like other fundamental ratios.

But I don’t agree, at least in part because profit margins should remain high, until readily obtainable labor is less scarce.  Getting there could be a long time.  Profit margins could remain high for a long time as a result, leaving  markets in a limbo zone, where it treads water as underlying value builds.

So profit margins should remain high for now.  Once labor is scarce globally,  and companies must pay more to get more or better quality labor, then will profit margins come under stress.

By David Merkel, CFA of Aleph Blog

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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