Short-Term vs. Long-Term Expectations

The recent recovery in risk assets has been a result of the expectation that the economy (and thereby corporate earnings) have troughed and will likely move back toward the prior cyclical peaks. So, how likely is that to happen? Consider the following graph that illustrates corporate profit margins for the S&P 500. Recessions are always bad for profit margins. If you examine each highlighted recession, profit margins have historically decreased 20% to 50% from their cyclical peak. This particular recession was especially brutal on profit margins, as they dropped from a high of approximately 9% to 4%. While top line revenues dropped by approximately 4%-5%, corporate earnings were hit hard as a result of the lagged response of cost cutting and adjustments. This drop in earnings contributed to the severity of the drop in the value of stocks. As the chart reveals, profit margins also tend to rebound as the economy recovers, often moving back to a level that is close to or in excess of the prior peak.

Profit Margins should improve, but to what degree?

Source: S&P Compustat, PMFA

It can be argued that profit margins will not return to prior peak levels, which were driven to a large degree by bank earnings. Nonetheless, it is very possible that in the short run, any meaningful top line revenue growth, coupled with the aggressive cost cutting that has already occurred, could push profits margins back near 7% or 8%. This would be similar to upward moves achieved during previous recoveries. Such a move would take corporate earnings on the S&P 500 to $70 or $80, even if sales do not meaningfully improve. At a price level of 16 times earnings, the S&P 500 could move to a range of 1100-1300, somewhat higher than current market levels. Of course it could also move substantially higher or lower, depending on market sentiment regarding the strength and sustainability of those earnings, which is exactly why making short-term judgments about where the stock market is headed is so difficult. That said, assuming that the economy does not take a dramatic step backward, a recovery in profit margins may surprise to the upside in the short term, allowing risk assets to rally further.

Long term, however, investors must question whether or not profit margins will sustain themselves at ever higher levels, especially if global economic growth is sustained at a slower pace than in the past decade or more. While we absolutely agree that the economy appears to be on a path toward growth, the ultimate question will be “how sustainable is that growth?” Recent profit margins before the market decline were well above their long-term average of 6%. Even with a return to economic growth, we remain skeptical about the ability of companies to expand profit margins back toward those pre-recession levels of 9%, particularly if deleveraging continues. Costs can only be cut so much; at some point, revenue growth must drive earnings growth.

As we have noted in Market Perspectives and other venues for many months now, the U.S. consumer – the primary engine of growth for the world economy for many years – remains in a tenuous position that simply cannot be resolved in a matter of weeks or months. With the value of the primary assets of a typical American household (their personal residence and retirement assets) still well below their peak values and persistently tougher credit conditions, spending is likely to remain constrained for some time. It should be noted that this doesn’t necessarily mean that consumers will continue to pare back spending from current levels, but their pace of spending growth moving forward may be more limited. With every dollar earned, a decision must be made to spend it, save or invest it, or use it to reduce debt. Clearly, consumers are now more focused on the latter two than they were just a few years ago. While the personal savings rate declined from its second quarter peak, we anticipate this renewed emphasis on personal balance sheet reconstruction will persist for some time, effectively displacing the previously prevailing ethos of borrowing to consume at any cost. As we showed in our May 2009 research paper, long-term corporate earnings will be strongly affected by economic growth, inflation, and margin sustainability.

High Debt levels must be addressed

Source: “Outside the Box” by John Mauldin

The chart above illustrates the current Debt/GDP situation. The growth in aggregate U.S. debt – both public and private sector – has been fueled by easy access to credit and ever lower interest rates for most of the 1980s, 1990s, and 2000s. This environment has been sustained for a long period of time. In fact, the U.S. first approached the prior 1933 peak in the Debt/GDP ratio as early as the late 1990s, yet the economy (and markets) continued to perform well for an extended period thereafter as outstanding debt continued to grow. However, it is highly unlikely that such a path is repeatable from where we are today. Therefore, there are two ways to reduce the debt mountain as a percentage of GDP: reduce the debt through write-offs/payoffs, or grow nominal GDP at a pace faster than the rate of debt growth.

Obviously, the reduction of debt through write-offs or payoffs would likely have a concurrent negative effect on the economy. Of the two, the clear preference would be for debt reduction through principal payments rather than write-offs, but a material redirection of capital to do so would still have to be offset by lower consumption, curtailing economic growth.

There is an alternative. If debt levels can grow at a pace below nominal GDP (real GDP plus inflation), then it’s possible that a period of fiscal restraint on the part of U.S. consumers does not have to result in another crisis. The authorities appear to be following this path, attempting to keep loan growth from shrinking precipitously while supporting asset prices through low interest rates. While this prescription has certainly provided stability to the system, the issue will be the sustainability of such a path from here and its ultimate effect on the level of inflation. Some inflation is necessary, but excessive inflation will have its own negative consequences.

If deleveraging was to take a strong hold and consumers worldwide truly rein in spending and focus on reducing debt, it seems reasonable to assume that Real GDP growth would be muted and that, try as they may, fiscal and monetary authorities will have trouble generating a significant degree of inflation. Even if the emerging consumer class in many developing countries continues to increase spending, a protracted slowdown in the U.S. and other developed economies would substantially mute the impact of growth in these smaller economies in a global context. If any of these scenarios were to occur, it does not necessarily mean that negative returns from risk markets await us over a long period of time. However, it would likely mean returns that are lower than historical averages.

In order to prevent deleveraging from taking hold, it is apparent that the policy makers are putting forth a coordinated global response that is unprecedented. Given that liquidity and interest rate structures are very stimulative (three-month LIBOR is currently 0.28%), risk assets could rally well beyond current expectations. The prospect of “growing” our way out of these problems is much more palatable then the government “taxing” or “spending” our way out of them. If debt can be held down in real terms to a pace of growth below nominal GDP growth (even in a slow recovery), then the debt to GDP burden would fall to more normalized levels over time, and we just may grow our way out of this problem. The ultimate cost of such a solution may well be inflation that is also higher than long-term averages. We will continue to monitor policy developments, as they will have dramatic and long-lasting implications on the outcome of this issue.

As is always the case for long-term investors, a focus on short-term events can distract one’s focus on the end game. By addressing current events in the way that we have herein, we are not attempting to prognosticate about exactly where the market will go. We still don’t believe that anyone has that answer. Although compelling, well-conceived arguments can be made for multiple scenarios, economic forecasting is limited by the vast number of dynamic variables that can materially change the picture at any point in time. We continue to believe that at this point in the economic cycle, with the tremendous rally that has occurred in risk assets, being very broadly diversified remains most appropriate, as does avoiding an unnecessarily significant directional wager on inflation or deflation. We anticipate the next few years may be more volatile than what most market participants are accustomed to. Therefore, a greater focus on active management in the asset allocation process and in underlying investment strategies may prove to be more beneficial than in the bull market from 1982 to 1999. Therefore, we will continue to look for opportunities that present themselves within the context of a client’s stated risk tolerance and need for returns. We have little doubt that they will continue to present themselves over time.




Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other source believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the sectors mentioned herein may not be appropriate for you. You should consult a representative from Plante Moran Financial Advisors for investment advice regarding your own situation.