Financial Times (Leaders & Letters page), 30th April 2007
This article appeared first in the FT on the 26th April 2007 in response to Jeremy Siegel’s Insight column
Jeremy Siegel presents a bullish case for US equity valuations (FT 26th April).
He first argues that profits need not fall, because they are not all that high, relative to GDP, once allowance is made for the fall in non-corporate profits. But this is irrelevant. Corporate output can and does vary as a proportion of GDP. Economic theory points to the stability of the profit share of output and, to decide whether corporate margins are high, it is essential to measure the profit share of corporate output.
If this is done, the data, which are available for the US since 1929, show two key things. One is that profit margins in 2006 were 32.3% against their average of 29.2%. The second is that statistical tests show that margins are strongly mean reverting (ADF statistic – 5.4). Both theory and experience point therefore to a marked fall in corporate profit margins.
As Jeremy points out, the current PE on 2006 profits is well above its long-term average. If returns on equity to investors are, as the data strongly suggest, stable over the long-term, then above average PEs point to an over-valued stock market unless profits are depressed. With the multiple and the margins above average, the market is clearly overvalued unless there has been a change in the long-term return. (As Jeremy’s own work has contributed so much to our knowledge in this field, Stephen Wright and I in our book “Valuing Wall Street” christened this long-term return “Siegel’s constant”).
Jeremy argues that his own constant will change, because transaction costs have fallen, and the world economy has become less volatile. If this were to happen, it would mean that the return to investors would fall and this must mean an equal fall in the return on equity to corporations. With current returns on corporate equity well above average, this requires an even greater fall in profit margins than that needed to bring them back to their average level. A fall in the required return on equity is unlikely and would anyway not reduce the degree to which the market is overvalued.