GMO's James Montier and John Hussman of Hussman Funds are among the market strategists who are convinced margins are unsustainable and doomed to fall to a long-term average.
To support their thesis, they both point to a somewhat obscure national income equation advanced by Polish economist Michal Kalecki. It looks like this:
Profits = Investment - Household Savings - Government Savings - Foreign Savings + Dividends
From there, Montier and Hussman conclude that record high profit margins are largely attributable to fat government deficits and depressed household savings. Indeed, that relationship appears to form a pretty tight correlation as seen in the chart from Hussman you see above.
Conversely, when deficits shrink and savings rise, profit margins will be toast.
The Rebuttal
However, not everyone agrees with that conclusion.
"S&P profit margins are high from structural reasons, not because of the deficit," argued Deutsche Bank's David Bianco, a strategist who has long-argued that margins are sustainable.
"This construct assumes that no savings are recycled as investment," he said. "This is not a small matter."
To be clear, Bianco doesn't explicitly identify Montier nor Hussman. Just their work.
He continued: "Simply said, the notion that savings reduces investment is a bold claim that runs contrary to basic macro economics. The continued extension of this misguided framework to the view that government deficits add to profits overlooks that someone's borrowing (for temporarily higher consumption or investment expenditure) is someone's savings (temporarily lower consumption or less direct investment expenditure, ie real assets, for indirect investment instead, ie financial assets)... In our view, profits are not a function of the degree to which households give back their wages as expenditures on consumption. This is a very flawed concept. This framework suggests zero sum economic terms and that savings are unproductive."
You can almost hear Bianco pounding the table.
For some context, Bianco is no raging bull on the stock market right now. As of his May 2 research note, his year-end target for the S&P 500 was 1,850 and he expects the next 5%+ move to be down.
Here's Bianco's full comment on the profit margin matter from his April 13, 2014 note:
S&P profit margins are high from structural reasons, not because of the deficit
S&P profits and margins recovered back to pre-crisis level by 2011. This led many to believe a well circulated argument that deficit boosted S&P profits. The crux of this specious argument that profit margins are boosted by a high government deficit and low household savings rate rests on the over simplification of "Profits = Investment + Consumption - Wages" to "Profits = Investment - Household Savings".
This construct assumes that no savings are recycled as investment. This is not a small matter. It represents a major conceptual flaw in this framework, which taints the entire analysis. The equation above would only be correct if all savings were stuck in a Keynesian liquidity trap. This is neither the point of the argument nor the general condition, thus the equation above fails to recognize that: Investment = Savings.
Income not spent on consumption expenditures usually goes into investment expenditures. Incorporating this normal condition negates the conceptual leap from the easily accepted "Profits = Investment + Consumption - Wages" to "Profits = Investment - Household Savings" as the latter expression of the former equation fails to acknowledge that profits are a source of household income. This ignores the real world relationship that exists in the economy of profits supporting consumption, but more importantly that profits also support a big portion of investment. Dividends might be added to the tail of the equation, but this doesn't suffice because even earnings retained by companies and proprietorships are invested on behalf of owners.
Simply said, the notion that savings reduces investment is a bold claim that runs contrary to basic macro economics. The continued extension of this misguided framework to the view that government deficits add to profits overlooks that someone's borrowing (for temporarily higher consumption or investment expenditure) is someone's savings (temporarily lower consumption or less direct investment expenditure, ie real assets, for indirect investment instead, ie financial assets). In short, the government and foreign variables can be set aside. What this really comes down to is: Are Profits = Investment - Household Savings?
In our view, profits are not a function of the degree to which households give back their wages as expenditures on consumption. This is a very flawed concept. This framework suggests zero sum economic terms and that savings are unproductive. In our preferred conceptual framework, investment drives growth. If households consume less then they invest more. Thus, profits are a function of cumulative past savings and the return on such capital stock as determined by risk and the competitive forces between labor and capital.