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Skyhigh Corporate Profit Margins Due for Crash: GMO Report

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Research from the noted asset management firm Grantham Mayo Van Otterloo (GMO) suggests that today’s soaring profit margins are due for a hard fall.

A new white paper, appropriately titled “What Goes Up Must Come Down!” offers a simple and elegant explanation for today’s high profit margins and expected mean reversion, but takes a long and wonkish analysis to get there.

James Montier, the paper’s author, is known for his analytic sophistication and uses a little-known economic model, called the Kalecki profits equation, to explain the key drivers of corporate profits. Without going through the steps he outlines, Montier is essentially looking for a way to understand why corporate profits today are at an all-time high despite the weakest economic recovery in post-war history. Profit margins today are north of 10% (click on chart, above), more than twice the average margins for the years 1926 to 1999.

GMO believes in the concept of mean reversion, that prices and returns eventually revert to an average so that current high returns will be balanced by subpar performance in the future. So barring some kind of structural change in the economy to justify sustained higher returns, Montier’s analysis expects there is a sound explanation for today’s high profits. And indeed, using the Kalecki equation, he finds an answer, and a troubling one at that.

James MontierIn a nutshell, Montier (left) shows that net investment has generally been the foremost driver of corporate profits. Yet private investment fell off a cliff in the economic crisis to near-zero levels! Nevertheless, the U.S. fiscal deficit filled the investment gap, and Montier’s nifty chart (Table 5 in his white paper) shows the recent dominance of government spending in the profits picture over recent years and specifically in 2011 (Table 6).

The prognosis for profits is therefore “not a pretty picture,” Montier argues, if one does not expect households suddenly to rally and assuming, as many observers do, that the government will start moving—at least after the election—to some sort of deficit reduction plan. Whenever this happens, and Montier forecasts no specific time, profit margins should collapse, bolstering GMO’s mean reversion thesis.