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Peak profits make ‘cheap’ US stocks extremely risky

Posted 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!

Economic outlook

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.

Posted on 21 June 2011 Categories: Hedge Funds, Investment Gurus, US Stocks

1 Comment posted by readers:

Comment by Bill near Slidell - 22 June 2011

American families owe more than $13,300,000,000,000. Some writer for the Wall Street Journal on the ‘Kudlow Report’ just told the truth, like I wrote here a while back. The only way to get out of this economic mess is to inflate the debt away, as was done by the WW II spending. Trying to pay it down without inflation will limit growth for decades, and could cause a depression.
Some people thing cutting spending is the answer. I think just the opposite is true. If a Federal debt agreement is reached that really does cut government spending quickly and radically, watch out. The dollar will strengthen making US exports more expensive. That will increase unemployment in the USA. More people won’t be able to pay their mortgages. Real estate prices will fall faster. Local government revenues will fall. They will lay off more, well paid middle class workers. A deflationary spiral could take hold. Once deflation becomes established, it is difficult to stop and can last for decades. The real value of debt becomes more and more burdensome as money evaporates. (I have cash, so I’ll be fine, as I get richer and richer, which may be the best argument why it will never happen!)
I just wish the heavy rain would stop blocking my Directv signal. At least the record heat is forecast to finally break. The drought was making the Formosan termites thirsty. I should probably be grateful that the tornado that I was just watching trying to form a few hundred meters to the east of here, didn’t. The rotation from the two cloud layers hitting couldn’t get it together.
At least Obama is finally going to start getting us out of Afghanistan. Talk about a waste of life and money! It will be interesting to see how long it will take the Chinese miners to get in there. They can live in all the stuff we built. What kind of bribes will they have to pay the Taliban warlords that will be running things as soon as we leave?
I’m still waiting for a thank you card from the Iranians for getting rid of Saddam.
Watch what happens to the Greek economy when the real austerity starts in a couple of months. It may contract a lot more.
Think Fukushima was a mess? Wikipedia ‘coronal mass ejection’ and watch this space for what could happen. (That is a pretty good hint.) You can see the Sun on the net at sdo.gsfc.nasa.gov, the web site for the Solar Dynamics Observatory. That cool orange image is what the Sun looks like through a solar telescope (addictive) that filters out all the light, except that which is emitted by a certain energy level of the hydrogen atoms. The Sun contains 99.9 % of the mass of the entire solar system. Without the ozone layer, it would sterilize the surface of the Earth in about a month. Sunburn on steroids. You wouldn’t have to water the plants or cut the grass, ever. Just as well, because the ultraviolet light would disintegrate your garden hose, and you couldn’t stay in the sunlight for more than a minute unless you liked blisters.
Did anyone see the big boat right behind Huntsman BACKING UP as he was announcing his candidacy for President? Not a good sign? But he is a very smart guy.

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