It's Not Different This Time

The four most dangerous words in investing are said to be "it's different this time." Someone uses them at the peak of every bubble to justify ignoring lessons of the past. 

I recently wrote a few articles about why I think the stock market is overvalued as the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and S&P 500 (SNPINDEX: ^GSPC  ) are less than 1% off their all time highs. One of the reasons was that corporate profit margins have reached unprecedented levels, and I expect they will revert to the mean, challenging profits going forward. Many people have once again said "this time is different," that you can't compare today to the long-term average, since U.S. companies' overseas profits have grown dramatically. Overseas profits have indeed grown, but it doesn't fully explain what's going on in the United States. It's not different this time. We're seeing increasing evidence that margins will revert over the next few years through higher wages.

Let's take a closer look.

Record margins
U.S. corporate profit margins as a percentage of the economy sit at all-time highs and 70% above the long-term average. This includes both the domestic and foreign profits of U.S.-owned companies and their foreign subsidiaries.

Sources: Bureau of Economic Analysis, Federal Reserve.

Why are margins so high? U.S. companies are making more profits abroad than ever before.

Sources: Bureau of Economic Analysis, Federal Reserve.

So why is it not different this time? Foreign companies are also making more profits in the U.S. than ever before.

Sources: Bureau of Economic Analysis, Federal Reserve.

The Bureau of Economic Analysis tracks foreign companies' profits made in the U.S. and separates them to calculate U.S. corporate profits. The BEA has data going back only to 1948, so our analysis must stop there. Still, going by the data available since then and employing some basic math, you can calculate the profits that both U.S. and foreign companies make in the United States.

First, corporate profits made in the U.S., whether by U.S. or foreign companies, are at their highest percentage of the U.S. economy since World War II ended.

Sources: BEA, author's calculations.

Total corporate profits in the U.S. are currently at 8.5% of GNP, 60% above their long-term average of 5.3%. Besides 2006, the year before the financial crisis, the last time corporate profits in the U.S. were this high was in 1950, when companies were benefiting from the post-war boom. However, the boom quickly ended with the enactment of the Excess Profits Tax Act of 1950 at the start of the Korean War. That law established a top corporate tax rate of 77%.

With companies taking a larger slice of the U.S. economic pie, someone else must be getting a smaller portion.

As you might have guessed, employee compensation as a percentage of GNP is near an all-time low.

Compensation currently sits at 51.8% of GNP -- 3 percentage points below the long-term average of 54.9%. Three percentage points might not sound like much, but to put this in perspective, if compensation were at the historical average, employees would earn $530 billion more this year.

The low wages consumers are earning look unsustainable over the longer term. And, by definition, if something is unsustainable, it will end.

There are two things that I expect to happen. One is that as the unemployment rate gets lower and jobs get harder to fill, especially for higher-wage workers, wages will rise as companies compete for workers.

At the lower end of the workforce, perhaps, it will be the government that's the key force in moving employee compensation up as a percentage of the economy. Earlier this month, President Obama promised to focus on decreasing economic inequality in the U.S. in his final three years in office. The president put forward many ideas, chief among them a call for an increase in the federal minimum wage, which has remained at $7.25 an hour since 2008. While the president didn't include specific numbers, Senate Democrats put forward a plan that would raise the minimum wage in steps to $10.10 and then index it to inflation. While $10.10 still doesn't sound like much, it is a 40% increase.

So over the medium term, I believe compensation will revert to the mean and we will see wage inflation, stressing corporate margins.

Foolish bottom line
While U.S. companies are making record profits abroad, earnings in the U.S. look cyclically high. Corporate profit margins are just one piece of why I think the S&P 500 is overvalued. You can read the rest of my argument here.

That said, predicting where the broad market will go in the short term is a game for fools (with a lowercase "F"). Stocks can always get more overvalued. When things get frothy, it's worthwhile to build up some cash on the side for when prices inevitably fall.

The Motley Fool has always taught that Foolish (capital "F") investors don't invest in the broad market. We invest in great companies at good prices, continue to educate ourselves, and hold on to our great companies over the long term. The market will fluctuate (sometimes massively), but great companies will win out over the long run.

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