Friday, January 12, 2018

Two sides to every story // Not Investment Advice

Jeremy Grantham:

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.

Grantham probably means you should expect profit margins to come down, which will hurt stocks.

To me, the important thing he's saying is there is something wrong with the system.

Grantham was quoted in an article dated October 2015, now more than two years ago. Here's corporate profits as a percent of GDP thru the third quarter of 2017:

Graph #1: Corporate Profits as a Percent of GDP
Not the best context for profit, but I have nothing else handy
No mean reversion yet. Profits are half again as high as they were in the 1950s and '60s. Twice as high as in the '80s and '90s. No mean reversion yet.

How long do we have to wait for the mean to revert, before we can safely say there is something wrong with the system ?


More recently, Grantham is still pushing the same story. Bloomberg, 3 Jan 2018, reports:

Grantham cited the recent acceleration of U.S. equity prices, a concentration of leadership in stocks and growing media coverage of events such as bitcoin’s surge and Inc.’s success as signs that the final phase of a bubble could be coming in the next six months to two years.

Another two years?

I grabbed some stock market performance data from FRED:

Graph #2
It's not price/earnings ratios or anything like that. It's just numbers from FRED. But if you look at where the purple and green lines were from 1975 to about 1987, and draw a straight line thru that, you come out right on top of the red line. Purple and green are now well below the red.

That doesn't mean a lot, because if the economy deteriorated you would expect the green and purple to be lower than what an old trend predicts. Still, by this measure, stocks are not outrageously high.

The graph uses a log scale. That's why the trends are straighter than you might expect.

The only "bubble" I can see on the graph shows up as purple gaining on green between 1995 and 2000. I don't see anything like that happening now.

Benefit of the doubt? Maybe purple is gaining on the other lines in the last few years. Maybe. It could be like the first couple years after 1995 when that bubble was just getting started.

Hey, I'm not a stock market guy. (Buy green, sell purple?) But my impression is still that, except for the one bubble in the 1990s, it's pretty much a straight-line increase. The recent years don't look like another bubble to me.

It looks to me like Grantham is repeating the mantra that gave him name recognition. Bloomberg:

Grantham, 79, is best known for his accurate prediction in 2000 that U.S. stocks would lose ground for the next decade.

Me, I'm sticking with my prediction of economic vigor, the thing that's going to give me name recognition. Financial costs are down, and that frees up money to be spend on things other than debt service. I expect that money to be spent on stuff that counts in GDP and puts people to work. You know, like a normal economy when it is doing well.

I could be wrong. Grantham could be right. But if we don't get economic vigor like we had in the latter 1990s (perhaps along with a bubble like we had in the latter 1990s) then Grantham is definitely right: something has gone badly wrong with capitalism.

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