What Goes Up Must Come Down

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This commentary originally appeared on Real Money Pro at 8:36 a.m. ET on March 21.

NEW YORK (Real Money Pro -- While the markets continue their resilient and consistent advance, some serious concerns (on the technical, economic, political and geopolitical fronts) are being thrust aside. Sir Larry Kudlow often says that "profits are the mother's milk of stocks, and for that matter, business and the entire economy" -- and I agree. But, in a series of recent columns, I have suggested that corporate profit margins, the most mean-regressing economic series extant, are likely to contract -- and with it, S&P 500 earnings will likely fall short and disappoint relative to consensus forecasts. GMO's James Montier has echoed and materially expanded my analysis on profitability in a March commentary piece that is a must-read by all investors. Corporate margins are the highest in history, at a time when the economy is on stall speed and does not yet show signs of a self-sustaining recovery. The condition, as a former Federal Reserve chairman might have called it, is the "profit margin conundrum." Graham & Dodd P/E Far in Excess of Current P/E "Whilst we at GMO fret over evidence of the strained nature of profit margins, the ever bullish Wall Street analysts expect profit margins to continue to rise! (Witness Exhibit 4). In our search for evidence of a structural break, this simple-minded extrapolation gives us some comfort because the Wall Street consensus has a pretty good record of being completely and utterly wrong." -- GMO's James Montier While price-to-earnings multiples at slightly under 14x are inexpensive by historic standards, they could be very expensive if the currently high profit margins mean regress. The divergence in current and reported P/Es to a smoothed-out version (Graham and Dodd) of the 10-year moving average in profits ("more normal" profit margins) is conspicuous, and takes the current 14x price earnings multiple to an expensive 24x. This simple comparison underscores how far earnings (and profit margins) are from "trend line" returns and demonstrates the risk if profit margins mean revert. 1 2 Last » Next › More from Real Money Kass: Shorted Apple Because It's Shortable! Cramer: Apple Upstaged iPad With Cash Plan Kass: The Market Is Overvalued Apple's Got to Drop Apple: Dirt-Cheap Options Play

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