Portfolio Strategy Review Q3 2015

by | Oct 21, 2015 | Portfolio Strategy

Economic Soft Patches, Profit Sustainability Concerns

Valuation remains a concern for US equities. Corporate profits drive stock market prices. If profits decline, stock prices will likely follow suit. The P/E ratio is a standard valuation metric for stocks: price is the numerator; earnings (aka profits) is the denominator.  The long-term average P/E is about 16. As compared to the trailing twelve month P/E of 16.5 – valuation looks reasonable. So what is the concern: profit sustainability?

Profit margins have historically shown a strong tendency to revert to its historical average of about 6% as competitive forces don’t allow for one company or sector to dominate forever. The S&P 500 profit margin is currently running close to 9%, or 30%-40% higher than the long-term average. Profits as a percent of GDP are similarly higher than historical levels. If a reversion to the long-term average were to occur, this would imply the market could correct by 30%-40%.

Asset Class Review

It was a volatile quarter with prices down among almost all asset classes. Concerns about economic weakness here and abroad caused a selloff. China is growing less than before; Brazil and Russia are in severe recessions driven by lower commodity prices. These forces caused a shift to safer assets such as bonds and cash. REITs also found footing after selling off sharply in Q2 because it appears that the Federal Reserve isn’t poised to raise interest rates this year. Energy and the broader commodities markets continued to fall.

Record profit levels have been driven by low interest rates (low corporate financing costs), a lack of wage increases (due to globalization and outsourcing), and technology. Many pundits and analysts postulate that technology, innovation, and the network effect are creating higher margins that will prove sustainable; therefore their reasoning goes that these forces may defy competition and the long-term average. Only time will tell, though I wouldn’t bet on the death of competition.

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