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A Little Detour into My Murky Past
Nearly a quarter of a century ago, I was a young, naïve, and foolish believer in an economic concept known as
rational expectations – an elegant, mathematically beautiful theory with no practical use. In Star Wars parlance, I had
effectively been seduced by the dark side. Thankfully, several of my university lecturers were determined to save me
from this terrible fate. They insisted on teaching me a very wide variety of approaches to economics including the
Marxist perspective and the something known as post-Keynesian macro. I owe them a huge debt of gratitude.
I thought at the time that these were at best esoteric distractions. Little did I know that they were going to provide
some of the most profound insights into fi nancial markets, illuminating many of the fl aws that conventional thinking
ignores. Early on in my career I was fortunate enough to interact with a number of colleagues who used some of these
tools to uncover observations that the mainstream had completely missed. This made an indelible impression upon
me, and these tools are still the ones I reach for when faced with trying to understand the world.1
Profi t Margins as a Case in Point
Today I fi nd myself once again digging through this toolkit, searching for a way to understand the development of profi t
margins. Currently, U.S. profi t margins are at record highs according to the NIPA data (see Exhibit 1). More freakish
still is that these record high profi t margins are coming during the weakest economic recovery in post-war history.
At GMO, we are fi rm believers in mean reversion, and as such record elevation in profi t margins causes us much
consternation. Of course, we are constantly on the lookout for sound arguments as to why we might be wrong in our
assumption of margin reversion. After all, believers in mean reversion are always short a structural break, and such
a break clearly matters. For instance, Exhibit 2 shows that in simple trailing P/E terms the U.S. market isn’t actually
expensive. However, the P/E is only one part of a valuation – it also depends upon the state of earnings. It is the
margin component that is dragging our return forecast down. If we are incorrect on our assumption of mean reversion
in profi t margins, then our forecast radically alters. For instance, if instead of falling to 6% over the next 7 years
margins stayed at today’s levels, our forecast would be closer to 4.5% p.a.
Clearly the fi rst two elements of Exhibit 2 are all about cyclical adjustment: we are assuming that the market goes to a
“normal” P/E based on “normal” E. Therefore, it is no surprise that we see the same point from a different perspective
when we look at a comparison of the simple trailing P/E using the Graham and Dodd P/E (Exhibit 3). The latter tries
to smooth out the business cycle’s impact upon earnings by using a 10-year moving average of earnings. Hence,
differences between the two measures are a statement of how far earnings are from their “trend.” The simple trailing
P/E is around 15x and the Graham and Dodd P/E is around 24x, again highlighting the divergence of profi ts from their
long-run normal levels.
Whilst we at GMO fret over evidence of the strained nature of profi t margins, the ever bullish Wall Street analysts
expect profi t margins to continue to rise! Witness Exhibit 4. In our search for evidence of a structural break, this
simple-minded extrapolation gives us some comfort because the Wall Street consensus has a pretty good record of
being completely and utterly wrong.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
A Little Detour into My Murky Past
Nearly a quarter of a century ago, I was a young, naïve, and foolish believer in an economic concept known as
rational expectations – an elegant, mathematically beautiful theory with no practical use. In Star Wars parlance, I had
effectively been seduced by the dark side. Thankfully, several of my university lecturers were determined to save me
from this terrible fate. They insisted on teaching me a very wide variety of approaches to economics including the
Marxist perspective and the something known as post-Keynesian macro. I owe them a huge debt of gratitude.
I thought at the time that these were at best esoteric distractions. Little did I know that they were going to provide
some of the most profound insights into fi nancial markets, illuminating many of the fl aws that conventional thinking
ignores. Early on in my career I was fortunate enough to interact with a number of colleagues who used some of these
tools to uncover observations that the mainstream had completely missed. This made an indelible impression upon
me, and these tools are still the ones I reach for when faced with trying to understand the world.1
Profi t Margins as a Case in Point
Today I fi nd myself once again digging through this toolkit, searching for a way to understand the development of profi t
margins. Currently, U.S. profi t margins are at record highs according to the NIPA data (see Exhibit 1). More freakish
still is that these record high profi t margins are coming during the weakest economic recovery in post-war history.
At GMO, we are fi rm believers in mean reversion, and as such record elevation in profi t margins causes us much
consternation. Of course, we are constantly on the lookout for sound arguments as to why we might be wrong in our
assumption of margin reversion. After all, believers in mean reversion are always short a structural break, and such
a break clearly matters. For instance, Exhibit 2 shows that in simple trailing P/E terms the U.S. market isn’t actually
expensive. However, the P/E is only one part of a valuation – it also depends upon the state of earnings. It is the
margin component that is dragging our return forecast down. If we are incorrect on our assumption of mean reversion
in profi t margins, then our forecast radically alters. For instance, if instead of falling to 6% over the next 7 years
margins stayed at today’s levels, our forecast would be closer to 4.5% p.a.
Clearly the fi rst two elements of Exhibit 2 are all about cyclical adjustment: we are assuming that the market goes to a
“normal” P/E based on “normal” E. Therefore, it is no surprise that we see the same point from a different perspective
when we look at a comparison of the simple trailing P/E using the Graham and Dodd P/E (Exhibit 3). The latter tries
to smooth out the business cycle’s impact upon earnings by using a 10-year moving average of earnings. Hence,
differences between the two measures are a statement of how far earnings are from their “trend.” The simple trailing
P/E is around 15x and the Graham and Dodd P/E is around 24x, again highlighting the divergence of profi ts from their
long-run normal levels.
Whilst we at GMO fret over evidence of the strained nature of profi t margins, the ever bullish Wall Street analysts
expect profi t margins to continue to rise! Witness Exhibit 4. In our search for evidence of a structural break, this
simple-minded extrapolation gives us some comfort because the Wall Street consensus has a pretty good record of
being completely and utterly wrong.
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