Profits, Earnings, And Living On Borrowed Time

We know the continued case for US stocks…bond yields are too low, bills pay nothing, and the P/E is slightly above average. The following paragraphs offer some history on the natural range of profits, earnings, and stock market streaks. Then maybe a case for a continued allocation to US stocks can be decided on.

First, as we can see, historically (through 2010) average corporate profits as a % of GDP were about 9%.

Through the 3rd quarter 2014, profits as a percent of GDP were over 14%.

There have only been a few other times historically in which profits as a percent of GDP have been this high.

Additionally, the following chart illustrates earnings and earnings estimates (red), the trend in earnings (Shiller & Crestmont), and a major disconnect.

Analysts obviously do not believe in trends.

As illustrated below, they also do not believe in mean reversion or earnings cycles.

As you can see there is a natural 10% upper and lower threshold to earnings within a cycle.

Lastly, the number of times we have had 6 consecutive years of positive gains (’09, ’10, ’11, ’12, ’13, ’14) in the stock market is uncommon.

The preceding charts were made available courtesy of Crestmont Research.

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Predicting a market top may be foolish.

However based on the natural ranges of:

1) Corporate profits

2) Earnings trends, cycles and durations

3) Price gain durations

I predict that being underweight US stocks over the next 5 years will be beneficial to your asset allocation performance.

That’s the rational part of my brain talking.

My emotional “lizard brain” says the economy is improving, stocks are going higher and I’m not going to sell too early.

So where should we look to allocate to?

We can see 50% of world GDP is generated by the emerging markets.

Source: JPMorgan

Additionally, emerging markets have a current CAPE of 10.5.

That’s the equivalent of where US stocks were back in the mid 1980s.

Again, that’s the rational part of my brain talking.

My lizard brain is looking at the negative emerging markets returns and saying there is no way I can convince myself nor my clients that a large allocation to emerging markets makes sense and is a smart allocation decision.

We need to remove our lizard brain from the asset allocation decisionmaking process.

This is the major challenge we need to overcome if we are going to be of more value to our clients.