Skyhigh Corporate Profit Margins Due for Crash: GMO Report

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.

In 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.