3 Gales Ripping Across the Market Will Hit U.S. Companies

Aside from the health care headwinds that Rodney was telling you about, there are three gales blowing in the markets in particular. Each one is making it increasingly difficult to expand the market’s price/earnings multiple and drive the major indices to fresh all-time highs. As a result, I think things are getting riskier by the minute, so be careful about how much new capital you invest right now.

The first gale is a strong U.S. dollar, which is pressuring companies with a large portion of foreign revenues. We’ve seen bellwethers as diverse as Caterpillar and Microsoft warn investors that a strong dollar has crimped their opportunities overseas. Their comments led to an intra-day swoon of more than 340 points in the Dow Jones on January 28.

The second gale of concern is corporate profit margins and cash flows. They’re at 50-year highs. As such, it will be increasingly hard to move the needle much more. Companies have already cut a lot of costs of operations through layoffs, consolidations, and reducing excess capacity so there’s no wiggle room left.

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The third gale is mean reversion. History shows that profit margins always revert to the mean. This makes perfect sense in the real world while the Wall Street best online casino sites struggles with the idea.

Wall Street analysts get seduced into extrapolating trends that simply cannot continue, but Main Street operates from a more rational set of rules. If margins are too high and unsustainable, competition can enter the space, undercut the price, and grab market share.

At 12.3%, profit margins are in nosebleed territory. They aren’t going to 14%.

Take a look at this chart…

Corporate Profits and Cash Flow as Percentage of Nominal GDP

No, it’s not a heart rate monitor, but a closer examination will certainly get your blood pressure spiking.

The line I want you to pay attention to is the thick blue one. At 12.3%, profit margins are at a level last seen around 1965. The high for the entire period going back to the late 1940s is about 13%. So, unless “it’s different this time” and economic principles are going to be tossed aside, we’re pretty much at the top.

I assure you: it’s never different “this time.”

Price/earnings expansion through an improvement in profit margins is virtually impossible from here.

There’s another important point to note from that chart. The shaded vertical areas represent recessions. See just how quickly margins come crashing to earth?

Events between 2000 and 2008 should be fresh in our minds. But, the prior recessions in the 1980s and 1990s saw significant margin contracts as well. Margins, like stock prices, tend to overshoot. The higher the climb on the upside, the greater they fall when the tide turns.

So be cautious with your large-cap holdings and tighten stops. Also, be slow to allocate fresh funds to large caps that are at historically high valuations.

And be ready to short small-cap stocks before it’s apparent that a bear market has started. I’ll alert you to the excellent opportunities out there when the time comes.

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John

Categories: Cycles

About Author

In 2007, John Del Vecchio managed a short only portfolio for Ranger Alternatives, L.P. which was later converted into the AdvisorShares Ranger Equity Bear ETF in 2011. Mr. Del Vecchio also launched an earnings quality index used for the Forensic Accounting ETF. He is the co-author of What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Previously, he worked for renowned forensic accountant Dr. Howard Schilit, as well as short seller David Tice.