During his recent interview with Tobias, Jesse Felder, hedge fund manager and Founder of The Felder Report Newsletter discusses why ‘Margins’ are the most important thing for investors to focus on right now – not earnings. Here’s an excerpt from the interview:
Tobias Carlisle: This market seems to be, it’s supported on … The multiple is very high, but earnings have also been very high for the S&P 500. Margins have been very high. It’s sort of at every part of it that you might want to look at, it all seems fairly extended. If any of that came back a little bit, you see some pretty substantial draw down in the market at least.
Jesse Felder: Well, I think you hit on it, that the number one thing that I’m paying most attention to right now is margins, because by earnings-based measures, stocks don’t look extremely overvalued. But on sales-based measures they do, and the difference is profit margins. So I think a lot of people who are using earnings-based measures don’t really understand this that well, that if you’re using an earnings-based PE to ratio, what have you, you have the embedded assumption that profit margins are going to remain at record highs indefinitely, that there will not be any reversion in those.
Jesse Felder: Historically, Jeremy Grantham has said that’s the most mean reverting series in finance. Warren Buffet wrote about it in ’99, in one of his articles for Fortune where he talked about, he said something along the lines of, “You have to be crazy to think that corporate profits can remain over six percent of GDP for any extended period of time.” And he goes, “If …” And so he was wrong about that, because profits have remained higher than that. But he was right in the fact that he said, “If you were to see a situation like that, it would create all kinds of political problems.”
Jesse Felder: I think that’s exactly what we’re seeing right now. With global populism on the rise, this is the labor share of corporate profits is at record lows. That’s the inverse of corporate profit margins. So corporate profits margins are only so high because labor has been getting a much smaller share than they ever have historically. So now labor is essentially revolting, through politics.
Jesse Felder: So you have Ray Dalio’s partner at Bridgewater, I’m spacing on his name right now, said that there’s all these forces right now that are working against corporate profits. I think if you look at what’s going on politically in that light, then you start to see the risk to profit margins and the risk to valuations over the next several years. People don’t understand the risk. If profit margins revert to historical norms, then you’re looking at an S&P 500 today that’s at a 40 PE, higher than the dot-com mania.
Jesse Felder: So that’s why my friend John Hussman has come up with one of my favorite valuation measures, is a margin-adjusted cape ratio, essentially. When you adjust for profit margins, stocks today are higher than they were in 2000, higher than they were at the peak in 1929. So I think investors who are using earnings-based measures need to be really really careful about profit margins. What is the embedded assumption that I’m making in profit margins today, and is that a safe assumption to make?
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