“Macro” Musings II

[Liberty]

Any thoughts or opinions on the current level of net profit margins? Do you see current aggregate net margins (on the S&P 500) as being sustainable?

 

I think common wisdom is that profit margins mean revert, so no. When sometime in the future interest rates and wages go up they will mean revert. Otherwise we get so much wealth transfer from the poor/middle class to the rich that we get revolutions. (And at that point they will mean revert :D)

 

What if the business mix has changed over time to include more high margins stuff (services, software) and less low margin stuff?

[frommi]

What if the business mix has changed over time to include more high margins stuff (services, software) and less low margin stuff?

 

That sounds like "this time is different", heard that a lot around 1999/2000.  :)

Higher margins always attract competition and when the worker class has less and less real money they buy the cheaper stuff regardless of moats or brands. So in which world should this be sustainable in the long run?

[Liberty]

What if the business mix has changed over time to include more high margins stuff (services, software) and less low margin stuff?

 

That sounds like "this time is different", heard that a lot around 1999/2000.  :)

Higher margins always attract competition and when the worker class has less and less real money they buy the cheaper stuff regardless of moats or brands. So in which world should this be sustainable in the long run?

 

"This time it's the same" is just as bad as "this time it's different".

 

Reality is more complex. Some things stay the same, some things change. We have to actually think about which is which to figure it out.

 

So let's think about this: Is it true that the business mix has changed over time? Is it true that there are businesses that have higher margins and that aren't seeing those margins being competed away all the way down (but rather the market gives them a higher multiples, so you might still not make more money by buying them, yet the margins can stay high and this has an effect on the average margin of the index)? Is it possible that automation is increasing profit margins in some industries by reducing the amount of labor needed?

 

I think that with things like software and pharma, margins can stay pretty high, and these things are a bigger part of the stock market than they were, say, 30-40 years ago.

[petec]

 

What if the business mix has changed over time to include more high margins stuff (services, software) and less low margin stuff?

 

I would counter:

 

1. If it had changed over time then margins would have risen over time but they just seem to have stepped out of the historical range quite suddenly.  James Montier at Grantham Mayo makes a good case that this is due to larger government deficits, but don't ask me to repeat the argument here ;)

 

2. High margins imply barriers to entry.  So to justify sustainably higher margins you have to justify sustainably higher barriers to entry.  How do you do that?  (Comes back to my Dupont argument.)

 

3. To buy this argument you have to be sure that the economy hasn't always looked like the new and exciting businesses are higher margin than the old ones.  I suspect it has, and that similar arguments have been made every time margins have been at a peak.

[petec]

 

"This time it's the same" is just as bad as "this time it's different".

 

I totally agree but I personally feel the burden of proof lies on those who believe the latter, especially when the historical series is so strongly mean-reverting and with good reason (free market competition).

 

My view is margins will fall when the economy finally recovers properly and a) companies invest to increase capacity, b) labour rates rise, and c) interest rates rise.

[indythinker85]

look in the Coinstar thread on buybacks. If current market cap is lower then future cash flows added up of say next 10-15 years, then a buyback is good for shareholders. It is bad if the stock is overvalued. So my guess is, some buybacks with borrowed money are good, and some are bad. If you think the stocks on average doing those buybacks are overvalued, then they are destroying value. But that is an average. Some are creating v alue, but some are destroying more value then the others create, so on average value would be destroyed if you think there are more overvalued companies buying back stock.

 

The thing I see Dalio not really mentioning is productivity. You cannot discuss debt markets without discussing productivity too.

 

More from Dalio http://www.valuewalk.com/2014/10/bridgewater-judges-sovereign-nations-success-economic-scale/

 

He said that it matters most in the long run. What i am missing is how in the world all the different ecnomies work together. At the moment we have a beautiful deleveragin in the US, but a deflation with austerity in europe and a debt bubble in china. Now is the US importing deflation through the currency and killing the beauty?

[Liberty]

I don't know either way. I don't really have an opinion on macro. I just wanted to point out that it's possible for this to be the case. I doubt Pfizer or Oracle will ever have the same margins as retail operations or the steel industry...

 

Lots of mistakes have been made by people who expect things to change too much. But a lot also came from expecting things to be the same (people who grew up with the depression always expected it to continue and the next one to be around the corner, people who grew up with lots of inflation always see inflation around the corner, etc).

 

But I just don't know. I want to be careful not to be too sure either way. There are lots of good arguments either way. For example, have you seen this:

 

http://www.philosophicaleconomics.com/2014/05/profit-margins-dont-matter/

 

Corporations seek to maximize their total profits–not their profit margins, not their sales volumes.  They sell their output at whatever price produces the [profit margin, sales volume] combination that achieves the highest total profit.  In environments where there is significant excess capacity and weak demand, that combination usually entails a low price relative to cost, i.e., a low profit margin.  Corporations aggressively undercut each other to sell their output.  In environments where there is tight capacity and strong demand, the combination usually entails a high price relative to cost, i.e., a high profit margin. Corporations don’t have to undercut each to sell their output–so they don’t.  They do the opposite–they’ll overcut each other, raise prices.

[frommi]

I think the relevant question is not if they mean revert, but when. I am 100% sure that they will mean revert over the course of the next 30-100 years. But i am not sure about the next 5 or 10 years.

As petec wrote a catalyst for that may be higher interest rates, higher wages, higher commodity costs or even deflation (and people have only money to buy low margin stuff and cost of capital does not mitigate that anymore).

So as long as we are in a stable environment (inflation 1-2%) margins will probably stay that way.

[maxthetrade]

MS makes an interesting point why profit margins won't mean revert:

http://www.businessinsider.com/ms-why-profit-margins-wont-mean-revert-2014-10

 

 

[yadayada]

I think a lot of industries have moved towards oligopoly duopoly structures? So then profit margins will be higher.

[frommi]

MS makes an interesting point why profit margins won't mean revert:

http://www.businessinsider.com/ms-why-profit-margins-wont-mean-revert-2014-10

 

Given that he is right than this is probably the catalyst for the mean reversion.

 

http://www.theglobeandmail.com/report-on-business/global-watchdogs-take-on-the-tax-avoidance-villains/article20710670/

 

[wisdom]

Capitalism at work:

http://www.ft.com/intl/cms/s/0/b2af94c6-5ff2-11e4-98e6-00144feabdc0.html?siteedition=intl#axzz3HeWCiZAM

[treasurehunt]

 

I would counter:

 

1. If it had changed over time then margins would have risen over time but they just seem to have stepped out of the historical range quite suddenly.  James Montier at Grantham Mayo makes a good case that this is due to larger government deficits, but don't ask me to repeat the argument here ;)

 

I don't have any quarrel with the claim that profit margins will probably decline at some point, but James Montier's argument appears dubious. You are talking about the article where he uses the Kalecki profit equation to "prove" that government deficits are the main cause of high profit margins, right? I remember reading this two or three years back and finding it pretty convincing. Unfortunately for Montier, the deficit in the US has declined from about 10% of GDP in 2009 to less than 3% of GDP in the most recent fiscal year, and profit margins have not gone down at all. I think 3% of GDP is a sustainable level, so it doesn't seem to make sense any longer to say that high government deficits are required for high corporate profit margins.

 

[jb85]

 

No evidence? I am sure they know the following equation: GDP = M * V. If you put the chart of money velocity over the chart of total debt in the US since 1900, you can clearly see that both times total debt exceeded 250%-275% GDP, V started falling significantly, and didn’t recover until the debt overhang problem had been solved. Maybe 2 instances are not evidence enough. But surely there is at least some evidence!

 

Gio

 

Started looking into this more and found a few charts.

 

1)

http://1.bp.blogspot.com/-zg5YFW3JN1Q/Uls8PpIbUWI/AAAAAAAAGyM/RP7ZRCqAa24/s400/()+GLobal+Public+and+Private+Debt+GDP.png

 

First chart seems to imply that at least other countries have had and still have much higher overall all debt (public and private) to GDP.  We are currently a bit over 300%, but Japan is at 600% now...and has been over 500% for close to 30 years!  So i don't know....calling the peak of that ratio looks to be pretty difficult.  similar to trying to time the top of the dot com bubble.  CAPE of about 30 at start of 1997 seemed like a good time to get out...but if you got out then, you woulda had to wait 10+ years before you got back in at lower prices.  Not sure many people (me included) would be willing to wait that long

 

2)

http://1.bp.blogspot.com/-fdXw5lHO26s/Uls7BzplpjI/AAAAAAAAGyA/7QZvLuAvfx4/s400/()+US+Private+Debt+To+GDP.png

 

now looking at only US total debt to GDP, it looks as if this ratio actually peaks near market bottoms.  total debt to GDP bottomed out in 1932 and 1875...both about 2 years AFTER the respective stock market peaks.  So not sure how much of a leading indicator this ratio is. 

[yadayada]

I would be very careful putting private and public debt together. There is a huge difference between the two.

[JEast]

Another shot across the bow -- Renminbi becomes convertible in Singapore dollars.

 

http://www.ft.com/intl/cms/s/0/64bac520-6a4f-11e0-a464-00144feab49a.html#axzz3HgRJ3qls

http://www.nesaranetwork.com/2014/10/27/the-chinese-government-announced-that-the-renminbi-will-become-directly-convertible-with-the-singapore-dollar-effective-tomorrow-morning/

[JEast]

Long ¥en Massacre -- Bank of Japan (BoJ) announced a surprise increase to its quantitative and qualitative easing (QQE) program.  I guess this is not a shot across the bow anymore, but first engagement.  Other Asian central banks will not site idly on their hands.

 

http://www.moneyobserver.com/news/31-10-2014/japanese-stock-markets-soar-boj-hikes-qe

[JEast]

And then in Europe, first retail bank goes negative interest rates for German businesses.

 

Retail and business customers with over €500,000 on deposit as of November 1 will earn a “negative interest rate” of 0.25%.

 

http://wolfstreet.com/2014/10/30/the-wrath-of-draghi-first-german-bank-hits-savers-with-negative-interest-rate/

[Liberty]

For those who can read french (or use Google Translate):

 

http://www.lesaffaires.com/blogues/bernard-mooney/pourquoi-j-evite-les-ressources-naturelles/573388

 

This graph basically tells the whole story. It's a commodity composite index of 19 different things:

 

http://www.lesaffaires.com/uploads/images/normal/fa9fe7e8dd8f9eb7b0638345a9588aaf.jpg

[tinhb]

I'm not sure it's relevant here but I happened to buy put on FXY(Japanese yen) yesterday. I've traded in and out of this for a while but what got me into the position yesterday was tbat 5000 contracts of 85 Jan 16 was traded. This large volume somehow lowered the price. 5000 contracts = US$1 mil. Somebody frontrunning?

[yadayada]

http://blogs.wsj.com/economics/2014/09/01/chinas-productivity-problem-drags-on-growth/

[Liberty]

http://oraclefromomaha.wordpress.com/2014/11/02/update-im-back-at-least-for-a-while/

[wisdom]

https://finance.yahoo.com/news/u-s--dollar-will--get-a-lot-stronger-than-anyone-can-imagine-205439383.html

 

https://finance.yahoo.com/news/inflation-vs--deflation---wait--you-re-both-right---says-john-mauldin-200902899.html

 

JohnMauldin - 2 good interviews.

[stahleyp]

I've been going through a 2001 Buffett speech and he talks about the market. He goes discuss interest rates and after tax profit margins as a percent of GDP affect prices.

 

Buffett wrote:

 

"Tow years ago I believed the favorable fundamental trends had largely run their course. For the markets to go dramatically up from where it was then would have required long0term interest rates to drop much further (which is always possible) or for there to be a major improvement in corporate profitability (which seemed, at the time, considerably less possible). If you take a look at a 50-year chart of after-tax profits as a percent of gross domestic product, you find that the rate normally falls between 4% -- that was its neighborhood in the bad year of 1981, for example -- and 6.5%. For the rate to go above 6.5% is rare. In the very good profit years of 1999 and 2000,the rate was under 6% and this year it may well fall below 5%".

 

It's hard to imagine interest rates getting too much lower (unless we do some Eurozone things) and profitability as a percent of GDP is over 10.5% from what I see. The only thing I can think of that would push prices up much higher is speculative fever. Am I missing something?

 

 

 

[wisdom]

http://www.bloomberg.com/news/2014-11-16/yen-near-7-year-low-before-gdp-kiwi-rises-on-sales-data.html

 

this could get the ball rolling. I see this as a sign of currency wars and potential deflation.