Profit Margins - Is the Ladder Starting to Snap? 

John P. Hussman, Ph.D.

Since mid-2014, the broad market as measured by the NYSE Composite has been in a broad sideways distribution pattern, with an increasing tendency in recent months for advances to occur on weaker volume and declines to follow on a pickup in volume. While capitalization-weighted indices have done somewhat better since mid-2014, the S&P 500 Index is unchanged since late-December. On the basis of broad market action across individual stocks, industries, sectors and security types, as well as a general widening of credit spreads and other risk-sensitive measures, we continue to infer a shift toward increasing risk-aversion among investors.

NYSE Composite Index

As I frequently emphasize, a resumption of favorable market internals and a retreat in credit spreads would suggest a fresh shift toward risk-seeking investor preferences that could defer the immediacy of our downside concerns. Unfortunately, that would not improve the dismal long-term returns that are already baked in the cake of current valuations. Presently, we observe obscene valuations coupled with evidence of a shift toward increasing risk-aversion among investors. For that reason, I continue to believe that the present moment will likely be remembered among a small handful of the very worst points in history to invest in equities from the standpoint of prospective return and risk. 

One of the central features of popular valuation measures such as price to forward earnings is that they take profit margins at face value. Year-ahead earnings estimates have the additional feature that analysts can (and nearly always do) base their estimates on the assumption that margins will improve in the future. We know from a century of evidence that correcting for the variation in profit margins produces valuation measures that are far better correlated with actual subsequent market returns. But when profit margins are elevated, the temptation to take them at face value (or extrapolate them to even greater extremes) seems too much for Wall Street to resist.

DYI Comments:  No doubt this is an overblown stock market that has now seen sideways action for more than a year.  Elevated profit margins that will soon begin their downward journey by reverting to their mean (most likely overshooting to the downside).  This will put severe pressure (valuations & profit margins) on equities and junk bond prices.  One to two year bear market in the magnitude of 45% to 60% is very possible.  Add on that the economy is dancing on a pin to stay in growth.  The chart from dshort show very clearly the economy is headed in the wrong direction.  To soon for a recession call but does raise one's eyebrows.
  

Also the Empire State Manufacturing and Philadelphia Fed Survey (see below) have both gone soft.  To soon to make a recession call but clearly unless less this data improves and pronto (next 3 months) then a recession will be headed our way.
  
ECONODAY
The international economic picture is under strain as the Economist Magazine lumped China and Greece together as their real estate markets get smashed.

Global housing markets

Property puzzles

EXHIBIT A is a powerhouse of the world economy whose GDP has grown by 158% over the past ten years. Exhibit B is a basket-case whose economy has contracted by 18% over the same period and where a quarter of the workforce is unemployed. China may think Greece an unlikely bedfellow, but the weakness of their housing markets ties the two together in our latest roundup of global house prices.

If this is the beginning of the long awaited China debt melt down and it co insides with a U.S. recession this will bring down Europe as well.  It is possible to have yet another world wide recession.  Too soon to tell at this point in time, but the data is definitely moving in the wrong direction.

My model portfolio remains very defensive.

AGGRESSIVE PORTFOLIO - ACTIVE ALLOCATION -  4/1/15

Active Allocation Bands (excluding cash) 0% to 60%

85% - Cash -Short Term Bond Index - VBIRX

15% -Gold- Precious Metals & Mining - VGPMX

 0% -Lt. Bonds- Long Term Bond Index - VBLTX

 0% -Stocks- Total Stock Market Index - VTSAX
 0%-REIT's- REIT Index Fund - VGSLX

[See Disclaimer]

DYI