Regarding the question “are stocks overpriced?” the topic usually is debated around the concept of sustainable corporate profit margins. High corporate profits are really the only good defense of the bulls’ opinion. If today’s record high corporate profit margins are sustainable then stocks may only be modestly overvalued. On the other hand, if today’s margins are going to revert to the mean, which is typical for corporate profit margins, then stocks need to go down 50% to reach equilibrium. Mean reversion of profits may be a lumpy experience where they stay high for some time and then suddenly fall as competitors finally get strong enough to compete away the high profit margins. Thus a bear shouldn’t be worried about the validity of the bear’s case if margins stay high for several years.
If workers were forced to accept a smaller share of the corporate gross revenue and that was the reason for lower profits then one must ask how can workers afford to buy back the product that they have worked to make? It seems that workers can’t because of pay cuts, layoffs, and jobs exported to EM countries. But supporters of high margins say not to worry because OPEC countries and China are busy buying American capital goods so as to build up their own countries. Supposing an OPEC country buys construction equipment from a U.S. manufacturer and builds office buildings in Dubai. This might seem to be a job creating activity. But what if the real estate development was an unsustainable, unprofitable bubble? What if potential tenants can’t afford to rent a beautiful new office or apartment in Dubai or in Ordos, China? What happens to the world’s GDP and to future demand if a developer builds unneeded real estate? The answer is that the building still needs maintenance even if empty and generating no rent. Also the building will deteriorate over time even if empty. This depreciation is a form of negative GDP as an asset wears away. If an asset was mistakenly built and counted towards GDP then it needs to be subtracted from GDP, perhaps in annual increments using depreciation tables. If someone overbuilt real estate and has to wait many decades for the economy to catch up then if demand finally catches up when the building is forty years old in theory the building is worthless due to depreciation. Also in forty years local economic needs and customs will have changed which may make the building obsolete, regardless of its physical condition.
Currently most Emerging Market countries, southern Europe and Japan seem to have a policy of the governments forcing banks to lend money to corporations even if they aren’t qualified for a loan and then pressuring corporations to create wasteful make-work jobs not needed by the companies regardless of the companies’ need to make a profit. This has created a fake, unsustainable demand for capital goods exported from the U.S. so that the lack of demand from underemployed, underpaid U.S. workers is offset by this bogus foreign “demand”.
Thus U.S. companies’ ability to make higher profit margins by cutting wages and yet not losing sales is based on unsustainable demand created by foreign governments. If EM countries decide to stop doing this or are unable to do this (perhaps the rising dollar could make these exports nearly impossible) then U.S. companies will experience a profit slashing demand shock.
Much of the world’s economy except for China and the U.S. has very low growth. China’s growth includes massive debt fueled stimulus that is not based on sound principles and which has resulted in wasteful building of unneeded, unaffordable, empty real estate. The construction counts towards GDP but it is a wasted resource and shouldn’t count. If China’s growth, hypothetically, is zero, then the world has only the U.S. as a driver of growth. Much of the U.S. growth of capital goods is due to exports to EM countries that may be spending inappropriately. If that is reduced then all the big sources of global growth will be gone!
Ultimately the mystery of how U.S. companies has record profit margins may be explained by sales to foreign companies of equipment used to inappropriately build a global real estate bubble. One must ask where will the low income residents of EM countries get enough income to afford to rent or to own expensive real estate?
Another way of looking at corporate profit margins is to assume the world is one fully integrated economy and then ask how will workers buy back the product they make if they are now getting a declining share of corporate revenue? If the inappropriate lending and welfare payments are cutoff then workers can’t buy back the product and corporate margins must fall back to normal which would make stocks fall.
Investors need independent financial advice about the risks of stock values going down because corporate profits are artificially and unsustainably too high. I wrote an article “Does GDP growth imply perpetually rising profit margins?”