the market’s P/E is a reasonable starting point for valuation but you also have to consider profit margins. after all, as a guy i once worked for used to say, “it’s only got a low P/E until the “E” goes away.”
after-tax corporate profit margins are running at 7.2% here in the u.s., which is in the 90th percentile of profitability performance over the last 80 years – the average over the period is 4.9%. the reason is principally because consumers have levered themselves and over-spent relative to their incomes. consequently, as all companies have some degree of operating leverage, this incremental spending bolsters corporate america’s bottom line disproportionately.
aggregate profitability in corporate america is THE single most consistently mean-reverting time series in finance. which makes sense – after all, if profits don’t mean revert, then capitalism is broke.
thus, even if the market’s P/E stays at 16x-17x, mean reverting profitability alone could easily hit stocks for 20%-30% over the next few years. just something to keep in mind.
