From GMO's Quarterly Letter

When we began building our forecasts, this series had a wonderfully mean-reverting look to it. There had been no obvious trend for the close to 50 years of data, despite plenty of good times and bad in the interim. And the appearance of long-term stability still seemed strong as late as the early 2000s. At the time we excused the new highs of profitability as the consequence of the housing boom and bubble in risk assets. Afterwards profits were good enough to fall through the old average in the financial crisis, although not to the lows we saw in prior recessions. And since then, after the fastest and sharpest recovery on record, we saw them rise well beyond anything the U.S. has ever seen. On this measure, while profitability is off of its recent highs, it is higher than any point in history before 2010. 

 

 And this leads to the quandary for thinking about the U.S. stock market. We cannot find any convincing evidence that the U.S. is deserving of trading at a premium P/E to the rest of the world. This profitability, however, could be read either of two ways. Either the U.S. has somehow unlocked a secret to permanently higher profitability or this is an extremely dangerous time to be investing in the U.S. U.S. profitability has never looked materially better relative to the rest of the world than it does today. The bull case would be that, for whatever reason, this profitability gap is sustainable and U.S. stocks are only mildly more expensive than the rest of the developed world given U.S. P/Es are only about a point higher. 

But, frankly, we have a hard time believing this bull case. U.S. out performance in recent years can be readily explained by the better trends in profitability, but that is a long way from saying that out performance was truly justified. From a macroeconomic perspective, maintaining such high levels of profitability in the face of low investment rates implies ever-increasing wealth inequality in this country, unless taxes were to be raised in a way that seems highly implausible. Generating sufficient end demand in the economy given the inequality would call on either the rich to start spending their wealth at signficantly greater rates than we have seen historically or the rest of households to spend more than 100% of their income, as they did in the housing bubble. It is hard to envision that an economy that relies on those foundations to be a sustainable one.

DYI Comments:  Elevated corporate profits to GDP will be a passing event.  Either competition or government taxes will be levied to move the percentage closer to its historical average.  As the presidential season heats up this will most likely become a hot topic as the U.S. swings from pro business to pro labor.  Currently today we are in during phase from pro business to pro labor.  This will not be a smooth transition as politics are noted for their ruff and tumble nature. But turn we will even if a Republican wins the White House this movement could only be slowed but impossible to stop.

The stock market with the Shiller PE10 at 25.87 is actually some where close to 30 or 32 times earnings due to these elevated margins.  Add on a low dividend yield of 2.08% you have the makings of an overvalued market poised for the real possibility for 45% to 60% decline.

So hang on to head while everyone else is losing theirs as better valuations lie ahead.

DYI