Mean Reverting Profits

Earlier this week I discussed the growing detachment between the stock market and the“real” underlying economy. One of the areas I touched on was corporate earnings that have been elevated by an immense amount of accounting gimmackry, cost cutting, and productivity increases. The problem, as I stated, is that historically earnings have grown 6% peak-to-peak before a reversion. Notice, I said peak-to-peak. The issue is that the majority of analysts now estimate that earnings will rise unabated for the next five years.

As shown in the chart below, earnings have never attained the currently expected growth rate…ever.”

However, this also applies to corporate profit margins as well. As Jeremy Grantham once stated:

“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 is correct. As shown, when we look at inflation-adjusted profit margins as a percentage of inflation-adjusted GDP we see a clear process of mean reverting activity over time.

Reversions occur both from peaks and troughs, therefore, when profits-to-GDP have exceeded their long-term average to a significant degree (1 or 2 standard deviations)that has been a subsequent reversion.  (Note: if I use nominal corporate profits the ratio is near 2-standard deviations from the mean)

Corporate profit margins have physical constraints.  Out of each dollar of revenue created there are costs such as infrastructure, R&D, wages, etc. Currently, one of the biggest beneficiaries to expanding profit margins has been the suppression of employment and wage growth and artificially suppressed interest rates that have significantly lowered borrowing costs. Should either of the issues change in the future, the impact to profit margins will likely be significant.