John Hussman had a really nice piece out this week and he riffed off the James Montier piece I cited last week. You can also see my analysis on corporate profits using a Kalecki approach here. His conclusion was similar to the one that Montier and myself came to. Dr. Hussman summarizes his point succinctly:
“What remains then is a fairly simple assertion: the primary way to boost corporate profits to abnormally high – but unsustainable – levels is for the government and the household sector to both spend beyond their means at the same time.
If we go to the data, we see the link between profit margins and deficits in the quarterly figures, but the tightest relationship is actually a causal one – large government deficits (as a percentage of GDP) coupled with weak household savings rates result in temporarily high corporate profit margins, with a lead of about 4-6 quarters.
The conclusion is straightforward. The hope for continued high profit margins really comes down to the hope that government and the household sector will both continue along unsustainable spending trajectories indefinitely. Conversely, any deleveraging of presently debt-heavy government and household balance sheets will predictably create a sustained retreat in corporate profit margins. With the ratio of corporate profits to GDP now about 70% above the historical norm, driven by a federal deficit in excess of 8% of GDP and a deeply depressed household saving rate, we view Wall Street’s embedded assumption of a permanently high plateau in profit margins as myopic.”
That’s really good stuff. If you’ve understood the dynamics of the balance sheet recession and the massive impact of the government’s spending and the bulging deficit you’ve been leaps and bounds ahead of other investors over the last few years. The same will be true in the coming 24 months as the downside risk to the deficit grows. As I mentioned previously, the current environment is relatively easy to predict because private investment is so low. Generally private investment bounces back sharply during a recovery and private investment can be notoriously hard to predict. But with private investment low on a historical basis we can see that the government deficit is carrying the burden. While investment is picking up it’s still not outpacing the effect of the deficit. And since the deficit is relatively easy to predict we can gauge the trajectory of the economy to some degree. So stay tuned. I still think corporate profits and the economy are on a positive trajectory, but as we head into 2013 those risks are going to rise SUBSTANTIALLY.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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