Yesterday’s upbeat news on the manufacturing sector enthused the stock market. The ISM Manufacturing Index climbed to 56%, its highest reading since April 2006. Equity investors took the obvious clue and reasoned that the economy is still bubbling, which of course it is. The trend encourages growth in corporate profits. Investors were in a mood to agree and the S&P 500 gained more than 1% yesterday.
The notion that corporate profits still have more room to run on the upside is no minority vision. The bulls are still in control of the psychological tone that permeates Wall Street and investment predictions generally. Yesterday’s equity rally is one source of the tone, but there are plenty of other wells of optimism to draw on.
One example: a proprietary equal-weighted index of economic and financial variables calculated by yours truly suggests that the broad trend was distinctively bullish in May. And after reading the ISM report, there’s reason to think that a rebound from this year’s first-quarter GDP slump is under way.
Optimism about optimism, in fact, is evident far and wide. For instance, reports that hedge fund firm Och-Ziff Capital Management Group LLC is planning an IPO remind that these are golden times for raising capital, reporting profits and otherwise basking in the financial glory.

The trend holds at the micro level and rises to the macro. Corporate profits as a percentage of GDP–at around 10%–are at their highest since just after World War II. That works out to around twice the pace that’s prevailed over the last half century or so. There’s no doubt that the U.S. economy has been humming by more than a little, at least when viewed through the prism of corporate America.
But we shouldn’t become overly complacent about corporate profits running skyward in relative terms, warns a new essay to clients of Guerite Advisors, a boutique mutual fund in Greenville, South Carolina. Citing Warren Buffett commentary from a few years back, Guerite asserts that reversion to the mean is a risk when corporate profits are riding high:

Why does gravitating back to the average (reverting to the mean) matter? First and foremost, the current level of the U.S. equity market has received a tremendous lift from rising corporate profits. A key factor to the stock market’s sanguine demeanor is the oft-repeated line that values remain “reasonable” compared to historical price-to-earnings (PE) ratios. The current trailing PE ratio for the S&P 500 Index is 18.3. This figure is often compared to the 57 year average PE ratio of 16.7. However, what is not widely emphasized is that the average PE ratio is based on average earnings over a wide variety of economic conditions. Applying an average PE ratio to maximum earnings (as is now the case) can allow an over-valued stock market appear reasonably-valued. Therefore, an investor must adjust the average PE ratio using an “apples to apples” adjustment. Using such an approach, the appropriate average (maximum earnings) PE ratio is 12.8, not 16.7. Cast in that light, the current valuation of 18.3 (versus 12.8) doesn’t appear so “reasonable”.

None of which means that the equity market is about to crumble. Indeed, warnings that corporate profitability is about to soften, if not tumble, have been with us for several years. And as we all know, the market can stay irrational longer than we can stay solvent.
Listening to the darker angels of investment forecasting would have been exactly the wrong thing to do in years past. No one knows how such advice will fare in the future, of course. But if you’re looking for reasons to pare back equity exposure and err a bit more on the side of caution, the profits-as-a-percent-of-GDP argument is as good as any.
Thomas Jefferson famously struggled with choosing between listening to his head and his heart. Investors have a similar challenge: weighing the compelling case of the bulls for the next few months or even quarters vs. the bears’ concern for the longer term. Looking at one to the exclusion of the other may offer clarity and focus, but look at both together and trying to square the long run with tactics for next week poses its own unique challenge.
Such tension, we think, will be with us for some time. In fact, from your editor’s perch, the tension looks set to rise.