Peak profits make ‘cheap’ US stocks extremely riskyPosted on 21 June 2011 with 1 comment from readers
There is a very popular current article on Bloomberg trumpeting that the S&P 500 is the cheapest it has been for 26 years. But beware the transitory nature of peak profits explains this temporary situation, and one that historical precedent suggests will pass very quickly.
Buying stocks when they are cheap sounds attractive, unless the measure of their cheapness is a false friend. That is one explanation for why US stocks have been falling recently, despite being at their cheapest in terms of price-to-earnings, plus of course the miserable economic fundamentals of an economy that shows little meaningful recovery from a multi-year slump.
Peak profit warning
Our friend Chirs Mayer over at Agora Financial recently highlighted the danger of peak profits. He highlighted a 25 per cent average net profit margin in the top 10 Nasdaq stocks that represent 40 per cent of the tech-heavy index:
This 25 per cent margin is without historical precedent. Chris Mayer warns: ‘This, then, is the Achilles’ heel of the market as far as the fundamentals go. Profit margins are extremely high and unlikely to stay there, which ought to lead to earnings disappointments down the road.
‘It was no surprise that Cisco Systems fell 16 per cent in a day after the market fretted over weakening profit margins at the tech giant.’
If you are not convinced by this argument then think about where these high profit margins have come from. They are the result of job cuts and overhead reductions that are one-off adjustments and cannot be repeated year after year to maintain profits, or there would be no business left!
Besides, again at the commonsense level, how long can companies continue to report extraordinary profits when their markets are clearly in deep trouble? That is to say US consumers are buying less because their take home incomes are falling, and never forget the US consumer is 70 per cent of GDP.
Stocks are not excessively valued indeed, but that does not mean that they cannot become a great deal cheaper, and even very oversold in a second act to the global financial crisis played out by the Greek debt tragedy.
Indeed, if you are a follower of charts you will know that shares tend to swing from overvaluation to severe undervaluation. We are on the way to the latter but we are not there yet.