Have corporate profit margins reached a permanently high plateau…doubtful

James Montier of Dresdner Kleinwort has another great article out.

In it, he takes Jeremy Siegel to task for his recent assertion that profit margins will not revert to the mean (go back to their average level of the past or below) and will stay at their current, record highs.

Jeremy Siegel is famous for being a professor at the esteemed University of Pennsylvania Wharton School of Business as well as being the well known author of Stocks for the Long Run.

Siegel’s argument is that U.S. based firms are deriving much more of their profits from fast-growing, overseas economies and that including private firms’ profits with public firms’ profits reduces the profit margins close to average.

Both of these arguments are suspect in Montier (and my) opinion.

As Jeremy Grantham puts it, if profit margins don’t mean revert (go back to average), then capitalism is broken. Competition will always drive aggregate profit margins down over time. This is an iron law of free market economics.

As for private plus public firms’ profit margins, the current margin of profits to Gross Domestic Product are at a 45 year high of 20%, far above the 16% average. Perhaps Siegel is looking at different numbers than Montier is.

Added to this, market history is littered with brilliant people who believe “it’s different this time.” As John Templeton put it, those are the four most dangerous words in investing.

A brilliant economist named Irving Fisher is famous for having said that stocks had hit a permanently high plateau in 1929. Unfortunately for Fisher’s reputation, the stock market proceeded to crash by over 90% over the following 3 years. Perhaps Siegel is hoping to supplant Fisher…

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Jeremy Grantham “has almost never been this dire”

Jeremy Grantham heads one of the best quantitative, value-oriented firms out there, Grantham Mayo and Van Otterloo (referred to as GMO for short). In his quarterly letter (www.gmo.com, you have to register to read their letters, but it’s worth it and I’ve never received a bit of unsolicited email from them), Grantham puts forward the same message he’s been delivering for some time: the market is grossly over-valued.

Grantham has been preaching this for some time, but his record in being right, though almost always early, is excellent. Heeding his words back in the late 1990’s would have saved you a lot of heart-ache if you were invested in the tech and telecom bubble.

Grantham’s theme in the past focused on a reversion to the mean of corporate profit margins. In this letter, he doesn’t spend much time on that subject, but he does take private equity, corporate tax rates, global financial markets, subprime mortgages, etc. to task. He simply sees too much risk taking out there and predicts it will end poorly.

I’ll just quote Grantham here because he says it best, “To conclude, I have been trying to come up with a simple statement that would capture how serious the situation is for the overstretched, overleveraged financial system, and this is it: In 5 years I expect that at least one major “bank” (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist.”

Wow, that’s quite a prediction!

He goes on to say, “I have often been too bearish about the U.S. equity markets in the last 12 years (although bullish on emerging equity markets), but I think it is fair to say that my language has almost never been this dire. The feeling I have today is that of watching a very slow motion train wreck.”

He’s not mincing words there, either.

What’s his suggested solution? In a word, “anti-risk.” He doesn’t take much time explaining what that means, but I think I can guess. Some investements will do a lot better than others if or when risk becomes a four-letter-word again. That may include shorting the market, buying commodities or gold, buying Treasury securities, or finding business managers who can benefit greatly in a market situation characterized by a lot of risk aversion.

In this last category, I’d put companies like Berkshire Hathaway, Leucadia and Fairfax Financial, companies that have a lot of cash on hand or are short the market and are waiting for a risk averse market to put their money to work. In the interest of full disclosure, I own positions in all three of these companies both personally and for clients.

A more risk averse market like we are facing usually scares people to death. In contrast, I see such situations as golden opportunities to buy when blood is running in the streets. In addition, I’ve purchased securities that I believe will do well even if the market does fair poorly.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Continued ripple effects

It’s been interesting to watch how the fallout in credit markets has rippled across other markets.

The initial indication of credit market stress showed up as subprime problems during late winter and early spring of this year. At the time, many market commentators were saying it was isolated and contained.

Then, as expected, credit tightening continued to ripple across other markets as it became more difficult to raise high yield debt. This, too, was described as a short term and isolated situation.

Now, it sounds like prime home equity loans are having trouble as are auto loans. The ripples keep showing up in more and more places. And, the market commentators continue to declare that it’s contained and short term.

Is this unusual? Not at all. This is exactly the type of thing that happens every time credit markets get too loose. As the credit market gets further and further away from its most recent problems, lower quality borrowers are loaned more and more money, or money is lent to borrowers at a rates not high enough to compensate for the risk involved.

At some point in time (forecasting if it will happen is easy, forecasting when is extraordinarily difficult), credit markets tighten again as lenders realize they have made bad loans.

This usually takes several years to unfold and almost always includes a large and “unexpected” crisis such as Long Term Capital Management in 1998, the Saving and Loan Crisis in the late 80’s and early 90’s, or the corporate credit squeeze in 2002.

I expect greater difficulties for banks (especially mortgage banks) that made bad loans, bond insurers that insured AAA tranches that were much more risky than they assumed, and mortgage insurers who looked only at recent data when pricing their insurance premiums.

At a later point in time, the market will become so disgusted that great buying opportunities will occur. I don’t think that time is here, yet, but I also assume that smart investors will start buying long before the bottom is reached. I just may be in that group, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Just for fun

If you’ve ever wondered if you can pick stocks successfully, I’ve got a website I’d like to recommend to you: www.marketocracy.com

The concept of the site is that there may be many people out there that are good at managing money, but have never had the chance or are simply in a different career field.

Marketocracy allows you to start out with a theoretical portfolio of $1 million. You pick the stocks you think will beat the market, make theoretical buys and sell orders, and then can track your performance over time. The site allows yo to compare your performance to the Dow Jones Industrial Average, the S&P 500, the Nasdaq and the top 100 players on Marketocracy.

It’s actually a lot of fun, too. I started a couple of fantasy portfolios there in the fall of 2001, and my picks have done pretty well. See here for yourself: Mike Rivers Mutual Fund and Rivers Capital. They’ve also let me experiment with some specific methods of applying the value investing philosophy before doing it in my own or my clients’ accounts.

If you’ve ever wondered whether you’re good at picking stocks, you may want to give Marketocracy a try. If you’re good, you may want to start managing your own money, and if you’re really good, perhaps you can become a professional money manager yourself!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Credit spreads too thin?

John Mauldin’s latest Thoughts from the Frontline Weekly Newsletter featured an excellent article by Michael Lewitt of Harch Capital Management.

The subject was the state of credit markets. This may seem like an unimportant subject to many observers, but it impacts the financial markets and global economy in ways most don’t grasp.

Specifically, the article talked about how credit spread are still very thin compared to historical average. What are credit spreads? Generally, they are the difference between the yield on a risky credit (corporate debt, mortgage backed securities) compared to a non-risky credit, which is considered to be a government bill, note or bond depending on the maturity of the bond.

When the credit spread is wide, market participants are worried about credit risk and are demanding a large spread over risk-free securities. When the spread is thin, the market is unworried about credit risk and is demanding very little compensation over risk-free securities.

Historically, credit markets go through swings of greater and lesser toleration for credit risk. Typically, the market gets complacent after a long period of low defaults and then gets over-concerned after a short period of high defaults.

Right now, we have just recently come off some of the lowest credit spreads in history. The normal result is a market shake-up that returns low credit spreads to high credit spreads. These can be very disturbing events, as it was in 1998 when Long Term Capital Management collapsed.

Credit markets tend to reflect the market’s toleration for bearing risk. When the market is complacent, it signals trouble may be ahead. When the market is worried, it frequently signals a great time to invest. In my opinion, we are on our way from complacent to worried, and that means opportunity lies ahead.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Reading list for investors

James Montier of Dresdner Kleinwort came out with a great letter recently. In it, he provides his recommended reading list as Investing 101.

The list includes classics like Graham and Dodd’s 1934 edition of Security Analysis, Chapter 12 of Keynes’s General Theory, Kindelberger’s Manias, Panics and Crashes, and John Burr William’s Theory of investment value. I’ve read all of these and found them very illuminating.

In the modern category, he includes Greenblatt’s Little Book That Beats The Market, Taleb’s Fooled by Randomness, and Dreman’s Contrarian Investment strategies. Once again, I’ve read each and really benefited.

In his psychological section, he suggests a bunch of books I haven’t read, but am very interested in such as Keith Stanovich’s Robot’s Rebellion, Tim Wilson’s Stranger to Ourselves, and Thomas Gilovich’s How we know what isn’t so. Gilovich’s title is enough to get my brain going.

His final category is hidden gems and also includes several books I haven’t read, yet. This includes Phil Rosenzweig’s Halo Effect, Robert Haugen’s The Inefficient Stock Market, and Jason Zweig’s Your Money and Your Brain. Halo Effect is particularly interesting because it covers how people characterize things as good based on a general impression and then mistakenly attribute favorable details based on their general impression. Before reading the book, I already know this is a great description of what goes on in financial markets every day.

His letter goes into much more detail about the books and why Montier recommends them.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Is now a good time to invest in the stock market?

To see a historical take on where we are now, read John Hussman’s latest.

Using historical analysis, he shows that today’s valuations do not bode well for long term returns on the overall stock market.

Enjoy!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.