Companies profit margins have been tumbling for the last 2 years while the stock market reached ever higher valuations. This divergence is the necessary condition for a market crash which is now certain and probably imminent.

The S&P500 should probably be trading at 1600 today, not 2000.

Don’t take my word for it, this is a well documented phenomenon that has happened already 6 times in the last 50 years.

It’s not different this time

US companies have seen incredible profits growth since the financial bottom of 2009 and this has created a very successful bull run for the last 6 years. The S&P500 increased a cool 180%, not even including dividends.

Companies have been making so much money since the recession that corporate profit margins as a percentage of GDP reached a 40-year high of 13% in late 2013.

Since that peak 2 years ago however, the trend has reversed.

For the last 2 years, profits have decreased 20%, while the stock markets has increased 20%. The stock market is overly optimistic, or in denial, which is common when you start to hear “it’s different this time” as justifications for high valuation. Denial is, by the way, the last step of a bubble before it bursts.

Could it be different this time?

Probably not. This scenario has happened many times before and it is well scripted:

1. Companies make record profits, markets are optimistic,
2. Forecasts are made believing this can go on forever,
3. Valuations are high, fueling more optimism,
4. Profits tend to be lower than previous forecasts, but valuations keep going up,
5. Until the gap is large enough to bring valuations back to earth, generating a crash.

Now that we know the margins have peaked and going down, it’s only a matter of time before the market prices it in.

Put your swim-pants on

Let’s have a look at the Domestic Corporate Profit Margin as a percentage of GDP, available through FRED, for the period 1950 to 2015 Q1. This specifically excludes profits made overseas to keep things comparable through long periods of time.

We can see several trends on this graph, but most notably that :

1. Each cycle is roughly 7-10 years long,
2. Recessions match periods of low margins and the end of a cycle,
3. There is always a peak in profits between recessions.

If history is any indication of the future, with the last recession in 2009 and the last peak in 2013, we should expect another recession in the next couple of years or so.

And it’s important because the corporate profit margin is a leading indicator of the stock market’s performance. Consequently, falling margins indicate that valuations need to go down. The problem is, this hasn’t happened yet.

“Only when the tide goes out do you discover who’s been swimming naked” – Warren Buffett

Margins peaked in 1997 before the stock market crashed in 2000. They peaked again in 2006 before the 2008 crash. The same happened in 1985, 1978, 1973 and 1966 before the market crashes of 1987, 1982, 1974 and 1966.

Looking back 50 years, on average we see that :

• Corporate Margins reach a bottom 2.5 years after a peak,
• Stock Markets reach a peak 1.5 years after corporate margins peak,
• Stock Markets reach a low 1 year after a corporate margins bottom.

Eat or dodge the bullet?

In the current context where margins peaked in Q3 2013, this would indicate that :

• Margins will reach a bottom in early 2016
• Stock Markets reached their peak early 2015
• Stock Markets will reach a low by mid-2017.

Based on this analysis, the stock market should have already peaked and be headed towards a crash now. Looking at the chart below, it might have already.

Based on this data, John Bogle would probably say that you can’t time the market and instead you should continue investing regularly.

Warren Buffett would probably say that it’s difficult to make a case for good investments now and would stash away cash to be ready for the next downturn.

Fidelity’s Director of Global Macro even says that “the market is not expensive”, adding to his argument that “[it] is important, because not many strategists believe this to be the case.”.

I am certainly very tempted to reduce my exposure to stocks, particularly in my tax-deferred accounts (eg. 401k), accumulate and hold on to cash for the next 18 months, waiting for an opportunity in the market.

What is your opinion on this?

Would you reduce your exposure to stocks? Hold on cash and wait for an opportunity? Or stay the course and keep investing?