Every Monday, John Hussman publishes incredibly robust market commentary.  He has become increasingly bearish as the equity rally we’ve seen since March 2009 steams forward.  His latest market commentary Investment, Speculation, Valuation, and Tinker Bell is no exception.  What sets Dr. Hussman apart from most market pundits is the amount of data and analysis he brings to the table – it’s often times overwhelming and probably too much for your weekend investor to get through.

In his latest commentary he provides an interesting quote from Buffett:

Warren Buffett was correct about profits as a share of GDP in November 1999 (and it would be useful if he remembered today how correct he was): “In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%… Maybe you’d like to argue a different case. Fair enough. But give me your assumptions. The Tinker Bell approach – clap if you believe – just won’t cut it.”

This quote caught my eye.  Using the incredibly handy FRED database excel plug-in, I decided to test this statement.  Below is a chart depicting Corporate Profits After Tax as a percentage of Nominal GDP.  Buffett was dead on with his 6% remark – since 1947 this measurement has averaged 6.1% through 2011.  In the chart below I assumed corporate profit growth of 5% for 2012 (I’m not sure what that number actually was but this is a quick and dirty analysis).  The result: corporate profits are extremely elevated compared to GDP, 2.3 standard deviations above the average if you use my 5% assumption for 2012, 2.2 standard deviations if you just look at 2011 as the latest.  Ironically it was right around 1999, when Buffett made that statement, that corporate profits as a % of GDP bottomed out and began their sustained run above 6%.

Although I don’t have the data, I searched for “Corporate Profit Margins” and found many charts that looked like the one below.  The embedded Grantham quote is just icing on the cake, if you can read it (I didn’t actually notice it until I pasted it into this post, score).

Some have pontificated that higher profit margins are the result of broader international activity among corporations and are here to stay – Hussman, who has done is homework, has found no convincing evidence of that.  In an earlier commentary he points out that “Elevated corporate profits can be directly traced to the massive government deficit and depressed household savings that we presently observe… one will not be permanent without the other being permanent… any normalization in the sum of government and household savings is likely to be associated with a remarkably deep decline in corporate earnings“

SO – what gives?  Probably corporate profit margins but WHEN that happens is anyone’s guess.

…and that is your contrarian view of the markets, thanks for joining.

P.S. Hussman’s commentary from the week before addresses the subject of corporate profit margins in much greater detail, including a version of the chart I so cleverly put together.  Unfortunately I read his posts in reverse chronological order.  For a much deeper dive on the subject read his Two Myths and a Legend post.

A few days ago I stumbled upon a real gem – it was the key note speech to the Financial Analysts Federation Seminar at Rockford College on August 9, 1981 delivered by Dean Williams who was a Senior Vice President at Batterymarch Financial Management.  The speech is called “Trying Too Hard” (link).

Dean lays out the idea that those in the investment management business are routinely trying too hard – there seems to be a vested interest in creating complexity as opposed to simplicity.  He compares finance to physics in that if you learned enough about the laws that govern the physical (or financial) world you could extend your knowledge or influence over your environment.  If you just worked hard enough – learned every detail about a company, discovered just the right variables for your forecasting models then earnings, prices, and interest rates would all behave in rational and predictable ways.  Unfortunately, in the financial world (and sometimes in the physical world) things don’t play out in rational or predictable ways, no matter how much understanding you develop.

Humans are just not good at predicting things – what earnings will be in a few years, when interest rates will peak, what inflation will be.  Most people in finance spend much of their time accumulating information to help make forecasts of all the things we have to predict.  Dean concludes that confidence in a forecast rises with the amount of information that goes into it but the accuracy stays the same.

So does this mean all professional investors are categorically useless?  No!  The good news is you can be a successful investor without being a perpetual forecaster.  Dean mentions one of the most liberating experiences you can have is to be asked to go over your firm’s economic outlook and say “We don’t have one”.

If there is a reliable and helpful principle at work in our markets its mean reversion – the tendency toward average profitability is a fundamental, if not the fundamental principle of competitive markets.  It’s an inevitable force, pushing profits and valuations back to the average.  This makes for a powerful investment tool.  It can almost by itself select cheap portfolios and avoid expensive ones.  The plain English equivalent Dean offers is “that something usually happens to keep both good news and bad news from going on forever”.

So besides having a healthy respect for mean reversion what other qualities can one bring to the table?  He offers a few:

• Simple Approaches – he quotes Einstein as saying “most of the fundamental ideas of science are essentially simple and may, as a rule, be expressed in language comprehensive to everyone” and remarks that his own reaction was “sure, that’s easy for him to say” but as long as there are people out there who can beat professional investment managers using dart boards, he urges us all to respect the virtues of a simple investment plan
• Consistent Approaches – establish your approach and stick with it.  He lists some of the top performing funds (circa 1981) and highlights the main thing they all had in common was the discipline to stick to their approach, to stay consistent
• Tolerance for the concept of “Nonsense” – or what the Zen call “Beginner’s Mind”.  Expertise is great, but it has a bad side effect – it tends to create an inability to accept new ideas
• Spend your time measuring value instead of generating information – As mentioned before, most of us in finance spend our time gathering information and using it to make predictions.  Dean advises us don’t forecast – buy whats cheap today; let other people deal with the odds against predicting the future

He goes on to mention an interesting study about man’s ability to forecast.  A Wharton professor named J. Scott Armstrong published an article called “The Seer-Sucker Theory” where he collected studies of experts’ forecasts in finance, economics, psychology, medicine, sports and sociology.  The summary of his findings is that expertise, beyond a minimal level is of little value in forecasting change.  The punchline of his findings was “no matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers”

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That’s a very rough outline of the speech – it looks longer than it is and it’s quite an enjoyable read; if you liked what you read here then go read the whole thing (link).