December 8, 2013

Kass: Flawed Case for a Bull Market

Joe Kernen: So tell me, Jim, what are your thoughts on the U.S. stock market?
Strategist: Stocks are cheap, trading at only 15x my 2014 estimate of $120 a share for the S&P 500. That's in line with the historic averages. But stocks are cheap with the 10-year U.S. note yielding under 3% compared to around 6% over the last five or six decades.

-- An imaginary CNBC "Squawk Box" interview between Joe Kernen and a strategist

The above conversation, though not real, has grown more popular and repetitive, embodying the market narrative these days with any of a number of market strategists. The simple market logic template is being trumpeted ad nauseam throughout the day in the business media not only on CNBC but also on Fox Business, Bloomberg, financial blogs and other media venues.

This morning's opening missive attempts to address and possibly refute the logic of this accepted (and simple) valuation argument that embraces the essence of current bull market thinking.

The cornerstone of the bull market case is that valuations are reasonable and not excessive by historical standards. It is further argued by the bulls that given the low rate of inflation (and inflationary expectations) and very low interest rates, the current level of valuation is justified and even inexpensive.

The conventional method of calculating P/E multiples based on stated or raw earnings is, arguably, a fundamentally flawed approach that assumes currently elevated profit margins and profits are sustainable. Indeed, measures that normalize margins have almost always correlated better to U.S. stock market performance over history.

It is only the cyclical (and elevated) position of profit margins that prevents recognition that equities are richly valued.

I would argue that to utilize earnings that reflect profit margin that are more than 70% above the norm (over a documented span of over 65 years) is an aggressive assumption and fails to adjust for the unique and changing conditions that contributed to the sharp improvement in margins since 2009 -- all of which are deteriorating and likely putting renewed pressure on margins.

Investors should consider evaluating current valuations from the context of normalized earnings not based on today's elevated (raw) profits and profit margins.

There are three important factors that have contributed to unusually high corporate profit margins -- all of which have begun to reverse.