Monday, March 3, 2014

Hussman Weekly Market Comment: Do Foreign Profits Explain Elevated Profit Margins? No.

The bottom line is simple. Corporate after-tax profits as a share of GDP, GNP (or even net national product if one wishes to use that number) are steeply above historical norms. This fact can be fully explained by mirror image deficits in household and government saving - a relationship that can be demonstrated across decades of historical evidence. As a result of a severe credit crisis and a sustained period of lackluster economic activity, we’ve seen a fiscal deficit (elevated transfer payments to households and shortfalls in tax revenue) combined with weak household saving. The combined effect is that companies have been able to maintain revenues while paying a very low share of income to labor and taxes. 
The role of international activity on profit margins is strictly secondary. Indeed, foreign profits of U.S. companies as a share of GNP have been contracting since 2007, are only about two-tenths of a percent above the 2009 low, and therefore do not have any material role in the surge in overall profit margins we’ve observed in recent years. Moreover, changes in foreign profits actually have a negative correlation with changes in domestic profits. Total profits as a share of national income have no natural reason to grow over time in any persistent way just because foreign profits have grown. 
Given the economic landscape of recent years, large offsetting sectoral deficits and surpluses are not surprising, but they should not be taken as evidence that the long-term profitability of the corporate sector has permanently shifted higher. Stocks are not a claim to a few years of cash flows, but decades and decades of them. By pricing stocks as if current profits are representative of the indefinite future, investors have ensured themselves a rude awakening over time. Equity valuations are decidedly a long-term proposition, and from present levels, the implied long-term returns are quite dim.