Profit Margin Forecast Does Not Support Market Rally
It’s important to understand what happens to profit margins in a recession. And make no mistake, we are very early in the recession that will most likely last well into 2021 in a best-case scenario. The hope for recovery based on record amounts of liquidity has merit, but it’s the very best-case scenario, not the most likely. Make no mistake, should the Democrats control the White House in 2021, we will see Trumps tax cut unwound and profit margins will fall further. Margins are always stressed well through a recession. To think the worst recession since the Great Depression will not have a negative impact is naïve. To think it will only last a few months is naïve. The current market is priced for a Trump White House, more stimulus spending, and still massive central bank money printing. We will continue to see government largesse to be sure, the bet is how much does that massive bridge loan and accompanying speculation (at the cost of higher future taxes) versus the real economy.
I get the don’t fight the Fed mantra—historically it made sense. I’m not trying to fight the Fed. I try not to get caught up in the daily noise of the market and focus on big picture themes and trends. But we are now at a point where central bank money printing is controlling free market price discovery and for me that is telling me the system is fragile and failing. Not a reason to make big bets of be bullish about the economy or outlook. The markets can move higher, but it’s speculative in the face of major policy uncertainty, not fundamental value driven.
By several metrics, markets are “stupid” expensive. The Shiller CAPE (cyclically adjusted PE) tells us the forward based returns for US large caps over the next decade are less than 1% annualized on areal basis (after inflation) and that’s about as bad as it gets. Here is a great reference from research affiliates on the returns you can expect from your asset allocation over the next decade. Their historical modelling has been very good for decades. But my favourite measure of valuation is enterprise value to EBITDA because it takes the whole capital structure (debt plus equity less cash) outstanding versus how much earnings it generates. If profit margins are heading lower as recessions historically portend, than profitability is going in the wrong direction, and the speculative central bank froth is more hope than reality.
If you want to bet on the Fed and other central banks controlling the system go for it, but if you care about big picture fundamentals, you have to understand that being aggressive at these levels is fundamentally a bad bet and far more speculative. For me, it’s always about investing with the highest probability outcome.