Uncomfortable Facts For The Bullish Bias
In a recent interview on CNBC, Steve Ricchiuto with Mizuho Securities points out the obvious to those that are paying attention.
The points that he makes are quite accurate but widely dismissed due to the current momentum push in the financial markets. However, one point in particular that I wanted to address was about valuations and profit margins. As Steve stated, companies are under pressure to maintain profitability in order to support rising asset prices. But, given the rise in employment and the squeeze on productivity, combined with global deflationary pressures and weak exports, this is becoming much more of a challenge.
The chart below shows a historical trailing valuations combined with corporate profit margins. The black dashed line represents 23x trailing earnings which has been the historical peak of bull market cycles with the exception of the late 90’s “dot.com” craze.
What is important to note is that for investors bad things have tended to happen when profit margins decline at a time when valuations have been elevated. The next chart shows this a little more clearly by viewing net profit margins as compared to the S&P 500 index.
It is the risk of a mean reversion in earnings/profits that is of the biggest risk to stock market investors currently. As I have discussed previously, earnings have a very regular habit of reverting from 6% peak to peak increases which is where earnings currently reside.
Given that global deflationary pressures are on the rise, the ability for earnings to follow the expected predictions through 2020 seem overly optimistic. This is particularly the case given the strength of the US dollar which is a drag on exports which comprises about 40% of corporate profitability.
Again, the points that Steve makes are absolutely correct. However, as I stated just recently, the Fed has now likely boxed itself into a corner and will likely raise rates even though “real” economic strength would suggest caution.
