Not So Random Thoughts

It has been a busy few months, not that the volume of postings to this blog (zero) is indicative. However, in the next few weeks, I will be able to share news regarding a new venture about which I am very excited and shortly thereafter release a white paper that I hope will cause many readers to reconsider the way they view the typical investment opportunity set.  But, until then, a lot has transpired in the global economy and I wanted to share with you some of what I think to be the most interesting and significant insights out there today.


THE RISK TRADE IS ON.  BUT FOR HOW LONG?

Plan sponsors and investors in general have become somewhat frustrated by the returns available from "low risk" investments such as cash and high grade bonds.  As a result they have progressively taken on greater amounts of risk in the quest for higher returns.  That is all well-and-good, but the question becomes whether and when they may have over reached and set themselves up for potential disappointment.

Consider:

• US Households now hold the largest percentage of their financial assets in risk assets (stocks, corporate bonds and mutual funds) since Q3 2000.  At 34.9% of total, holdings in these risk assets is just short of the 60-year high of 38.4% reached in Q1 2000 (blog).

• Spain, just a couple years ago, seemed on the verge of imploding.  This past month the Kingdom of Spain was able to issue notes that traded BELOW those of the US Government. Two years ago, they paid more than 7 percentage points more than Uncle Sam (article).  Even Greece has been able to issue bonds at a yield of 5% in spite of the fact that their finances (Debt/GDP) and employment situation are in worse shape than when the crisis began (blog).

• And even the riskiest markets are becoming more expensive.  Last year we saw investors gobble up offerings from Nigeria, Ghana, Mozambique and Zambia. The interest rate spread on Eurobonds issued by such frontier markets has fallen to below 400 basis points versus US Treasuries while the gap between JP Morgan's Emerging Market Bond Index and Frontier bond markets narrowed to a record 68 basis points this past month (article). 

In summary, spreads are narrow:

Issuers have flooded the markets:

And "safe" assets have been shunned:

Which raises the question of whether we've gone too far.  I don't believe we are there yet, but the caution lights are on and a reduction in risk is advised.  In a recent speech, Federal Reserve Governor Jeremy Stein cited the work of Harvard professors Robin Greenwood and Samuel Harrison who developed a credit-based early warning measure - simply the ratio of the volume of non-investment to investment grade issuance (rather than the more typical relative price measure, the comparison of spreads).  At prior stress points, this ratio reached extreme levels.  Though we are not quite there today, we are in the neighborhood (blog).  .  

STILL, THE SEARCH FOR RETURN CONTINUES

Traditional asset classes are getting pricey when measured against historical norms, whether we're looking at stock P/E ratios, bond yields or credit spreads.  So perhaps it's not surprising that hedge fund assets have reached new record highs as investors seek alternatives.  Hedge Fund tracking firm HFR noted that Assets Under Management at hedge funds reached new highs in each of the past seven quarters and that hedge funds now managed in excess of $2.7 trillion (article).  Yet, at the same time, hedge funds as a group posted their worst Q1 results in six years, and over the past 12 months, hedge funds were up just 8.53% compared to the S&P 500, up 19.32%.  Since the beginning of 2011, the HRF Equity Hedge Index (long/short funds) has actually lost more than 7% while the S&P is up 59% (article). Defenders of the industry will note that the word "hedge" implies they should lag in an up market because of the downside protection offered when things turn bad.  We will see, but investors should be very comfortable with the strategies employed by their managers and understand how they have performed in tough periods in the past, because the testing of the "hedge" may be forthcoming. 


WITH LITTLE HELP FROM EARNINGS

Over time, earnings drive stock prices - or so we have been led to believe.  In the short-run, this isn't necessarily the case as the value one places upon each dollar of earnings (the P/E ratio) can fluctuate based on expectations for the future or on current levels of risk tolerance (see above).  However, if earnings growth really is the longer-term fundamental link to equity performance, one might begin to get a little nervous.  From the last earnings peak (Q2 2007) through the first quarter of this year, we have seen the second weakest earnings cycle in more than 50 years.  Previous cycles have averaged 6.0% compounded annual growth as measured from peak-to-peak. Currently, we are on track for just 2.6% annualized -  and though well below the norm in terms of magnitude, in terms of duration, this cycle is just about average.

ROOKIE MISTAKES?

As interest rates hover near record lows, corporate treasurers have been quick to take advantage and lock-in the attractive funding costs.  Corporate debt levels have climbed, even as interest costs have fallen.  At the same time, the US Government has decided to issue its first-ever floating rate notes (FRN's).  Instead of locking in today's low rates, taxpayer interest costs will fluctuate in line with the market.  As rates rise, so will interest costs.  Should rates fall, costs may go down, though that benefit is limited as we are already close to the zero floor.  It seems to be a one-side trade and not one in the taxpayer interest.

Not to be outdone by the Treasury Department, the Federal Reserve has been lengthening the maturity of the Treasuries it holds in its portfolio.  The $2.3 trillion portfolio now shows bonds with a maturity of more than 10 years comprising 26% of holdings (versus 18% just four years ago).  Maturities of between five and ten years account for 37% of holdings versus 26% as recently as 2010.  Short-term notes (91 days to one year) were 23% of holdings prior to 2008.  Today they are zero.  This means, the Fed has taken on more interest rate risk just as rates trade near historic lows.

It appears the US Government (and by extension, taxpayers) have taken the opposite side of the bet from Corporate America.

THE DARK SIDE OF QE?

Supporters of the Federal Reserves' massive quantitative easing programs (aka QE1, 2 and 3), when confronted with the question of why things haven't worked out better, say "it wasn't big enough" - an argument that could be made no matter the size of the program or the outcome.

If you want to see what big does, however, just look at the Bank of Japan and their impact on the Japanese government bond market. The JGB market is larger in size than even the US Treasury market.  In spite of the smaller economy, the BoJ holds nearly the same amount of its own government debt as does the Fed.  So what can go wrong?  In reality, plenty.  The BoJ is, essentially, the Japanese bond market, having pushed all other players to the sideline.  For the first time in 13 years, the benchmark 10-year bond went untraded - not one single trade - for more than a day.  Overall trading volume is down nearly 70% from the same period last year.  When a central bank intervenes in a public market, prices are naturally distorted - in this case pushing yields lower than might be expected.  Given the lack of liquidity in the market, traders and investors worry what happens when the big buyer tries to catch his breath.  The answer is that yields can spike dramatically in a short period of time, leaving bond investors with large losses (article).  Better to sit on the sidelines or go elsewhere seems to be the result.

Meanwhile, savers are penalized while debtors reap the benefits of cheap money.  As discussed in a previous posting, "Winners and Losers (Nov 17, 2013), while the low interest rate policies have bailed out the banks, boosted the stock market and real estate, those with money on deposit have lost ground to inflation.  Richard Barrington, an analyst at Moneyrates.com, estimates that U.S. savers have lost $758 billion since the crisis began due to the erosion of purchasing power from the difference in interest earned and inflation  (article).  The McKinsey study cited in my earlier posting looked at the cost by estimating what savers could have earned had rates been in a more normal rate state relative to the level of inflation.  In either case, the costs are not insignificant.

HAVE I PAID MY FAIR SHARE YET?

And how can we let April 15th go by without commenting on taxes?  By this year's tax deadline, Americans as a group paid roughly $3 trillion in federal taxes and $1.5 trillion in state taxes, an amount greater than they will spend on the necessities of life - food, clothing and shelter (article). 

And, as the tax take has climbed, wealthier Americans continue to shoulder a larger portion of the federal tax burden.  According to the Tax Policy Center, the top 1% of earners, who take home 17% of all income, now pay 29.3% of all taxes (article). 

Many will argue that this is fair, or that the "rich" should do even more.  But just who are these 1% er's? According to a study by Thomas Hirschl of Cornell and Mark R. Rank of Washington University, 12% of the population will find themselves in the top 1 percent of the income distribution for at least one year during their career.  39% of Americans will spend at least a year in the top 5 percent and more than half will spend at least a year in the top 10%.  An astounding 73% will spend a year in the top 20 percent of the distribution. So rather than thinking of the top group as a fixed bastion of fat cats who deserve to be flayed annually, perhaps we should remember it is most people who dream the dream and often get pretty close, only to fail to stay there that are supposedly not paying their fair share (article).

But at least we're not the Europeans (yet).  The chart below from the consultancy of Ernst & Young shows the number of days of work it takes for citizens of a given country to pay their respective tax burden:

WHAT TO DO?

To those readers who agree that the topics raised about are potentially troublesome, the question of what to do next remains paramount.  With traditional asset classes historically expensive, economic growth below trend, the unknown consequences of Central Bank interventions yet to be felt and aggressive return hurdles to be met, we all have our work cut out.

I hope to offer at least one alternative in my coming white paper.  Please stay posted.

It's the Great Rotation, Charlie Brown

In the 1966 animated movie, “It’s the Great Pumpkin, Charlie Brown”, Linus van Pelt sits in the pumpkin patch on Halloween evening, waiting for the Great Pumpkin to arrive while his friends trick or treat from door to door gathering candy and popcorn balls.  Unfortunately, for Linus, the Great Pumpkin never shows.

Today, there’s lots of talk about “The Great Rotation” – an idea that as the economy recovers, rates will rise, investors will abandon bonds and equities will soar based on a better economy and better earnings.  Like Linus, investors who believe in this real world coming, will be disappointed.

Over the past year, the S&P 500 is up by more than 20% while earnings per share have climbed only 4.2% (even less excluding financial stocks).  Thus, investors have already been factoring in improvement into their willingness to pay more for each dollar’s worth of today’s earnings.

The flaw in their thinking is twofold:   

• First, stocks tend to do better when rates are falling, than when they are rising
• Secondly, there are two “components” to earnings – operating and financing, and rising rates will dramatically challenge the second of these

When we think of how a company works, we assume without much afterthought, that it does better when the economy does better.  However, let’s examine this a little bit more.

A company makes its widgets, or provides a service, which they sell for a certain amount.  However, there was a cost to manufacturing and selling that widget or service – materials, electricity, labor, marketing, etc.  The difference between these costs and the sales price is the operating profit – or what we think of as “the business”.

There is, however, a second, less considered component to earnings, and that is the financial component.  In order to make their widgets, the company had to invest in plant, property and equipment.  Usually, they will have to sell equity or borrow money to fund this investment.  Whether they choose to issue equity or bonds, borrow from the bank, set the term of the borrowing, etc. is a financial decision every bit as important as the decisions made in manufacturing its product.

Over the past few years, many companies reacted to the Fed's decision to artificially lower interest rates (Quantitative Easing) by borrowing to fund their investments.  As evidence of this, we can see how debt outstanding as a percentage of assets has risen since QE was introduced in 2008.

Even when accounting for the cash that has built up on balance sheets (borrowing for future purposes), leverage has still increased.  This is most clearly see if we subtract cash retained on the balance sheet from the total debt amount (giving us Net Debt) and express that as a percent of assets.  Such an exercise shows a rise in leverage over recent years to 14.2% of assets (from a 15-year average of 11.5% and a 2008, pre-QE low of 7.1%)

Interestingly, however, the overall cost of this borrowing has not grown, even as the amount borrowed has.  At the end of 2012, interest expense fell to 1.78% of sales from a 15-year average of 3.88% (and note it had never been below even 3% of sales until 2009).

So let’s say a company sells it widget for $100, and its cost of materials, labor, etc was $90.  Then their operating, or business, margin is 10 cents on the dollar.  Now, let’s subtract the costs of borrowing, currently 1.78 cents.  So the bottom line profits are 8.2 cents for every dollar of goods sold.  If, however, the cost of borrowing were closer to “normal” (3.88% of sales), the bottom line would be more like 6.1 cents.  In other words, you could expect earnings to fall roughly 25% even though the “business” environment hasn’t changed at all.

Yet another aspect of financial management relating to the low rate environment engendered by QE is the option many companies have followed to borrow at low interest rates for the purpose of buying back stock.  Remember, there are two ways to grow EPS, grow the earnings or shrink the number of shares.  Buoyed by QE, companies have opted to buy back shares, allowing EPS to grow faster than earnings overall (in some instances, outright earnings declines have been “converted” into EPS gains through a shrinkage of the share base). 

For the market as a whole (the S&P 500 index), In each of the past five years, operating income per share, has grown faster than overall operating income – evidence of a share base shrinkage (A positive numbers in the chart below indicate share buy backs.  A negative number, share issuance).  As rates rise, this practice of borrowing to repurchase shares will diminish and the ability to manufacture EPS growth will be further challenged.

Prima facie evidence that such financial machinations are still alive and well, surfaced earlier this week when Carl Icahn tweeted about acquiring a large stake in Apple Computer.  Icahn stated that Apple didn’t even need to grow its business for its share price to climb from $525 to $625 per share - they could simply borrow money at 3% and buyback shares that were more dear.  So whilst this financial maneuver is still viable, investors will be pressed to continue it should the cost of borrowing climb. 

In simple terms, any rise in interest rates will bring an end to the ability companies have had to manage the financial component of their businesses, even as the economy improves and helps their operating business.

There is one final element to managing the “financial” component of earnings that has nothing to do with interest rates.  It has to do with taxes.   As tax rates have come down over the years and as US companies do more business in lower tax jurisdictions, the effective taxes they have paid have fallen.  In other words, they get to keep more of the money they earned – another boost to the “non-business” side of earnings. 

Looked at from an economy-wide perspective (using the National Income and Product Account data from the US Bureau of Economic Analysis), the effective tax rate paid by US companies has fallen dramatically, especially in the past decade.  For the most recent 12 months, companies have paid out a little more than 18% of their earnings as taxes.  That’s down from a 50-year average of roughly 34% - a reduction of almost 50%.  To put this into some perspective.  If today’s effective tax rate of 18% were to return to the 25% rate which was the norm as recently as 2002 – 2006, the net margin would decline from 8.1% to 7.4% – corresponding to an earnings decline of just over 8.5%.

Unlike interest expense and share buybacks, I don’t necessarily think this is a trend that is going to reverse soon, but by the same token, I don’t see much room for improvement, especially as debt-laden Governments, worldwide, look to increase their revenue base.

So Linus and equity bulls, whilst I admire your faith and convictions, evidence would seem to be against the arrival of The Great Rotation.

Brace Yourself for Mediocre Returns - Part 2, The Equity Edition

While equity markets have more "moving pieces" than their fixed income counterparts, their longer-term outcomes can likewise be broken down into a handful of understandable and forecastable components. When approached in this manner, we see that returns from US and Japanese equity markets in the coming decade are likely to be poor, while returns from the currently "troubled" markets of Europe are likely to be substantially better.

It is a given that there are only two ways to make money from an equity - either you are paid a stream of dividends, or the price another party is willing to pay you for your shares differs from the price you paid (Dividend + Price Change).  In general, the Dividend component is readily observable and tends to be less volatile while stock Price Changes are more volatile and, in the short-run, more unpredictable.

To better understand the portion of return due to Price Change, we can further decompose that piece into Earnings Growth per share and the price one is willing to pay for each dollar's worth of those earnings (i.e. the P/E Ratio).  Both are somewhat volatile, but less so than the overall Price Change itself.  To simplify further, I like to sub-divide the Earnings Growth component into Revenue Growth and the change in the profitability of those Revenues (i.e. the Profit Margin).  Taking all this together then, if we know with certainty just four variables: Dividends, Revenue Growth, Profit Margins and the P/E Ratio, we will know with certainty the return from an equity (or equity index).

Fortunately, two of these components are relatively stable over a period as long as a decade (Dividends and Revenue Growth), while valuation and profitability are more volatile -- and it is this change in Margins and the P/E Ratio that ultimately drives returns.  Thus a sensitivity analysis featuring these two unknowns is called for.

Equity earnings tend to be cyclical over time (see chart) and gauging market value on a single, spot observation can be mis-leading -- especially when earnings are well above, or well below, their trend.  As of June 30th, the P/E Ratio on trailing, reported earnings of the S&P 500 index was 15.5x, below the longer-term norm of 17.0x (the median valuation since Dec 1959).  Based on this, one might conclude that the market is cheaply-valued.  What is left out of such a simplistic analysis is that the earnings part of that calculation is not at the norm, but rather a cyclical high.

Instances such as this tend to occur when margins are well above their norms, even as they are understood to be generally mean-reverting.  Today, S&P 500 margins are near one of these cyclical peaks.  The chart below was first published in my initial blog posting, "The Profitability Illusion" (June 15th), and depicts year-end S&P 500 net margins over the past 15 years.

A longer-term chart using a different set of data, the National Income and Product Accounts from the Bureau of Economic Analysis, which details economy wide profits, delivers much the same message (note how current margins appear to have broken out of their long-term channel.  I showed in "The Profitability Illusion" how this is largely due to the low interest rates engendered by the Fed's QE policies).

Thus, a valuation analysis which adjusts for the margin's deviation from its norm and which assumes dividend growth in line with earnings (as long as the current payout ratio is near longer-term norms), revenue growth in line with historical trends (typically that of nominal GDP) and a valuation component (P/E ratio) that returns to its long-run median over a period of ten-years should provide a decent assessment of where returns are headed as cycles run their course.  Those who disagree with my assumptions of a return to normal margin can use the accompanying sensitivity tables and observe returns under a range of margin and P/E inputs.  However, I would direct doubters back to "The Profitability Illusion" which discusses in some detail why over 2 percentage points of the current S&P 500 margin is illusory and unlikely to be sustained.  In any case, the range of returns can be illuminating and the dispersion of returns, not as wide as one might assume.

I turn first to the United States and use the S&P 500 index as a proxy for US Equities.  Over the past 50+ years, a median valuation of 17.0x earnings is the norm (I choose to use a median as opposed to an average because out-sized values can distort its calculation.  In full disclosure, the average P/E has been 17.6x).  Margins have averaged 6% for the past 50 years and have proven throughout to be mean reverting.  Today, though they stand near record highs of over 8% and in this analysis it is assumed they will slowly return to the 6% average.

 For this exercise, we also assume 5.5% annual compounded nominal revenue growth (in line with historic norms) and a 2.14% annual return from dividends (the current yield).  Putting this all together, our best guess return estimate for US Equities over the next 10 years is 3.9% per year.  If you want to assume record margins continue, you could up that expectation (see table below), but just to 6.8%.  Under no reasonable scenario, are double digit equity returns in sight.

S&P 500 10-Year Return Estimation (5.5% Nominal Revenue Growth, 2.14% Annual Dividend Return, Various Margin and P/E Scenarios)

13x          15x         17x         19x           21x 4.0% -2.8% -1.4% -0.2% 0.9% 1.9% 5.0% -0.6% 0.8% 2.0% 3.1% 4.1% 6.0% 1.2% 2.6% 3.9% 5.0% 6.0% 7.0% 2.7% 4.1% 5.4% 6.6% 7.6% 8.0% 4.1% 5.5% 6.8% 8.0% 9.1%

Taking Japan next we conduct a similar analysis, though using the historically lower 3.0% margin levels and nominal revenue growth.  Though Japanese valuation data is distorted somewhat by 10+ years of a great bubble, we feel a normalized P/E ratio of 20.x, higher than that of the US, can be argued, though we show a range of 12.5x to 27.5x in the sensitivity below.

MSCI Japan 10-Year Return Estimation (3.0% Nominal Revenue Growth, 1.77% Annual Dividend Return, Various Margin and P/E Scenarios)

	12.5x	15.0x	20.0x	25.0x	27.5x
2.0%	-5.7%	-4.0%	-1.2%	0.9%	1.9%
2.5%	-3.6%	-1.9%	0.9%	3.2%	4.2%
3.0%	-1.9%	-0.1%	2.8%	5.0%	6.0%
3.5%	-0.4%	1.4%	4.3%	6.7%	7.7%
4.0%	0.9%	2.8%	5.7%	8.1%	9.1%

Moving on to the European markets and the UK, we reach a somewhat happier, though still below historic, level of return.  For the UK market we use similar revenue (5.5%) and normalized margin assumptions (6.0%) as we do for the US.  For the continent, I discount both revenue growth and margins by 0.5%, in line with historic observations.  Again, under a broad range of valuation and margin assumptions we see the following:

MSCI United Kingdom 10-Year Return Estimation (5.5% Nominal Revenue Growth, 3.95% Annual Dividend Return, Various Margin and P/E Scenarios)

	10x	12x	14x	16x	18x
4.0%	0.8%	2.6%	4.1%	5.5%	6.7%
5.0%	3.0%	4.8%	6.4%	7.8%	9.0%
6.0%	4.8%	6.7%	8.3%	9.7%	10.9%
7.0%	6.4%	8.3%	9.9%	11.3%	12.6%
8.0%	7.8%	9.7%	11.3%	12.8%	14.0%

MSCI Europe (ex-UK) 10-Year Return Estimation (5.0% Nominal Revenue Growth, 3.71% Annual Dividend Return, Various Margin and P/E Scenarios)

	10x	12x	14x	16x	18x
3.5%	-0.2%	1.6%	3.1%	4.4%	5.6%
4.5%	2.2%	4.1%	5.6%	7.0%	8.2%
5.5%	4.2%	6.1%	7.7%	9.1%	10.3%
6.5%	5.9%	7.8%	9.4%	10.8%	12.1%
7.5%	7.4%	9.3%	11.0%	12.4%	13.7%

My conclusion is that long-term returns from the major developed equity markets are quite likely to remain in single digits -- and below 5% in both the US and Japan.  This realization, combined with those in Part 1 (which looked at fixed income markets) is that most plan sponsors will have great difficulty achieving their projected return assumptions, even under the most optimistic of market conditions.  Obviously a new perspective on managing funds is called for.  In coming posts, I will make some suggestions.


Sources Used: Bloomberg, Zack's Research System, Bureau of Economic Analysis, MSCI Barra, Brett Gallagher

The Profitability Illusion

The current near-record level profit margins of the S&P 500 are largely an illusion, created solely by the fact that interest costs have fallen precipitously, even as overall debt levels have increased.  Operating profitability, is actually below average.  As the Fed’s Quantitative Easing program is unwound, earnings are at significant risk

Current profit margins for S&P 500 companies remain near historic highs even as the broader economy struggles and real income growth remains anemic.  The stock market trades near record levels supported, if not by fundamentals, by promises of the Fed to hold interest rates near historic lows.  Today though, the certainty of those promises is being discussed with potentially very negative consequences for US and Foreign Markets.

Market bulls point to high profitability and supportive market action as well as benign valuation as reason for their continued positive stance.  Indeed, market participants are by many measures, as bullish as ever (hedge fund net longs, investor sentiment measures).

However, analysts, like myself, who believe that margins tend to be cyclical in nature, caution that today’s high margins are a reason for restraint, not celebration.  Traditional valuation metrics like P/E ratios, tend to understate the valuation of markets when margins are well above average, as they are today, leaving open to question whether the factors supporting the market are capable of remaining in place for an extended period.

Bulls will counter that we have witnessed a permanent shift upward in margins given the now global nature of production and the ability of corporations to manage costs better than ever by using offshore operations when beneficial.  This same argument is often cited when explaining why US personal income growth remains anemic.  While on the surface this is a believable narrative, the data does not back it up.

When margins are decomposed into their component parts:

• ·         operational factors (sales less the direct costs of production)
• ·         tax factors (the percentage of sales one forfeits in taxes) 
• ·         financing factors (amounts paid due to corporate financing decisions), and
• ·         extra-ordinary items (one-off items, not likely to be recurring in nature)

it becomes obvious that the historic profitability of the S&P 500 today relies solely on the fact that interest costs have fallen precipitously during the Fed’s period of QE even as overall debt levels have increased.

Current net margins are quite high by historical standards (8.04% versus the 15-year average 6.55%).  However, “operational margins” (the profitability of a company apart from their taxes and financing decisions) are now actually below average – so much for the benefits of global production.  The reason for the discrepancy between margins as generally discussed and operational factors has to do with the very low level of interest expense (1.78% of S&P 500 sales compared to an average of 3.88%), even though overall leverage (debt as % assets) has risen to 14.2% from the long-term average of 11.5% (Averages use year-end figures calculated from Dec 1998 through Dec 2012).

The charts which follow demonstrate this dynamic quite clearly.  After a bump during the period 2005 – 2007, interest expenses have fallen dramatically in spite of the fact that debt levels climbed (most precipitously in 2009).  To measure leverage, I have chosen to show both Total Debt to Asset as well as Net Debt to Asset measures.  It is my belief that net debt better hints at corporate vulnerability to leverage as it takes into account “tactical” debt issuance where retained cash can, theoretically, be used to immediately reduce leverage should borrowing costs reverse).

The chart below shows “operational margin” levels since 1998.  Current readings are slightly below average.  Should interest costs rise and encroach on overall business profitability, it is net margins that will have to suffer disproportionately.

Sources for all exhibits: Brett Gallagher, Zack’s Investment Research

Two conclusions can be drawn from the above.  First, given the low level of interest rates, further progress in margin enhancement via lowering interest expense without paying down debt would seem limited and operational metrics must improve if current margins are to be sustained.

Secondly, should rates reverse their downward trend, interest costs could have the opposite effect on profitability as financing costs rise dramatically.  If interest expenses revert to their historic average, net margins would fall below 6% (all else equal, this results in a 25% earnings decline from today’s levels).

IN CONCLUSION, assuming continued sluggishness in economic (and, hence sales) growth, high levels of leverage and a bottoming of interest rates, maintaining margins above the norm is unlikely and reversion to mean becomes a more likely outcome than a secularly higher level of profitability.  In such an environment, earnings are vulnerable as are P/E multiples, meaning equities themselves are at risk. 

In the next two postings to this blog, I will provide long-term return assumptions for US, UK, Continental European and Japanese equities (under a range of margin and P/E assumptions) as well as a variety of government and corporate bond markets using a proven valuation methodology.  The results will have significant implications for plan sponsors and other investors.