Are companies' high profits bad for stocks?

(MoneyWatch) You would think that the fact that corporate profits have reached a record 11 percent of GDP would make everyone bullish about stocks. However, highly regarded money managers, such as as GMO's Jeremy Grantham and John Hussman of the Hussman Funds have been issuing warnings instead. Why would they think that's a problem? Let's see why that's the case and what if any implications there are for investors.

There's a strong tendency toward reversion to the mean in many areas of investing. There's no law for mean reversion like there is for gravity. But consider that when you have periods when stock returns have been well above average, it's likely that valuations have risen. Higher valuations forecast lower future returns. Similarly, when returns have been well below average, it's likely that valuations have fallen, and that forecasts higher future returns. Of course, there are no guarantees. That's why there's no law of mean reversion in stock prices.

• Why you should wary of fast-growing companies
• Six ways to avoid expensive investment mistakes
• How recessions impact stock returns

Corporate profits relative to GDP also has a strong tendency toward mean reversion. Elevated profit margins are associated with weak earnings growth over the following five-year periods, and depressed profit margins are associated with unusually strong earnings growth over that horizon. This tendency is exactly why many prefer to use the Shiller PE 10 ratio which normalizes inflation-adjusted earnings over a 10-year period.

Jeremy Grantham is warning investors that profits are "weirdly high, unless we're in one of those wonderful secular shifts that people talk about but almost never see." The high level of margins represents a red flag for the stock market, at least in his mind. The logic is simple. Corporate profits as percent of GDP can't grow forever or they would crowd out everything else. There's a tendency for mean reversion of profits as percent of GDP because of the cycles in the economy. Another factor is that when margins are high, new competition enters, and vice versa. What has enabled corporations today to expand profit margins is the persistently high unemployment rate we have experienced. The excess supply of labor relative to demand has given corporations pricing power relative to the cost of labor, allowing profit margins to rise.

Over time, profits as percent of GDP have tended to revert to a mean of about 6 percent. We are now about 70 percent above that. The combination of high valuations and high margins is what has Grantham and Hussman, among others, worried. Should you be?

As regular readers of this blog know, my crystal ball is always cloudy. With that said, there are some important points you should keep in mind.

• The fact that margins are high isn't a secret. Thus, prices already reflect this information, as well as the risk that margins might shrink. And, if the tendency to RTM of profits was a good market timing signal, why don't we see evidence of market timing skills from active managers?
• While one might argue that margins would shrink if/when labor gains more pricing power, that environment would also reflect a stronger economy. Thus, while margins might shrink, that doesn't necessarily mean that profits will. In addition, a stronger economic environment might also lead to a shrinking in the risk premium demanded by investors. That would lead to a rise in P/E ratios. As an example, corporate profits as a percentage of GDP fell from about 8 percent in 1996 to about 6 percent in 1999 and the S&P 500 Index returned 26 percent per year.
• Given the huge profit opportunity, there's a tremendous amount of effort devoted to finding links between stock prices and fundamental metrics such as sales, earnings, dividends, measures of profitability, and so on. While it seems logical that profit such metrics should be related to stock prices in some way, the challenge is to coming up with a profitable trading rule using that information. Success in finding such a rule has proven elusive. As one example, we have been hearing the profit margin argument for some time. As an example, Financial Times columnist Tony Jackson was alerting readers nearly two years ago about the "extraordinary level of margins on both sides of the Atlantic." He warned: "If it's too good to last, it won't." The problem for investors is to know when should we ignore such arguments, and when should we listen. Unfortunately, unless your crystal ball is clear, there's no way to know.

As Warren Buffett advised in his 2013 letter to Berkshire shareholders: "I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it."

A great anomaly is that so many investors worship at the idol of the Oracle of Omaha, yet do the opposite of what he advises. With that in mind, you might ask what Buffett has been doing in the face of record profit margins. In February 2013, he ignored Grantham's and Hussman's warnings, and Berkshire participated in the $23 billion acquisition of Heinz.

The bottom line is that my advice is unchanged. You'll always be faced with reasons to sell stocks. The world and the financial media will provide them to you daily if you pay attention. But paying attention to, and acting on, such warnings is the loser's game. Certainly Buffett is ignoring them. The winning strategy is to have a well-developed plan that incorporates the virtual certainty that you will be tested by bear markets every few years. Make sure that your stock holdings don't exceed your ability, willingness and need to take risk. And stick to your plan, rebalancing and tax managing along the way.

Image courtesy of Flickr user 401(K) 2013.