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Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications and FICS-created content. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.

Has the beginning of the end of the bull market begun?

As profitability reverts to the mean, stocks will stagnate or decline.

  • By Mark Hulbert,
  • MarketWatch
  • – 06/25/2014
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Few paid attention a couple of weeks ago when the government announced that corporate profitability had declined markedly last quarter.

Yet future historians may eventually look back and pinpoint that report as the beginning of the end of this aging bull market.

That's because the first-quarter's decrease could signal the long-awaited return to historically average profitability levels. If so, the stock market will have to struggle mightily just to keep its head above water over the next five years.

Here's the sobering data: According to the latest calculations of the U.S. Department of Commerce, corporate profits in the first quarter of this year represented 8.8% of gross domestic product. That's the lowest level in nearly four years, and represents a big drop from the 10%-plus profitability that prevailed in the last quarter of 2013.

Those who focus on corporate profitability have worried for some time that such a decline was imminent. That's because, in the past, profit margins have exhibited a strong tendency to "revert to the mean," according to James Montier, a member of the asset allocation team at Boston-based GMO. In other words, margins in the past have eventually declined whenever they rose significantly above their long-term average, and vice versa.

That long-term average is 6.3%, according to the government's data. Unless corporate profitability has reached some kind of permanently high plateau, the recent drop is just the beginning of a much bigger decline.

What would it mean for the stock market if profitability reverted to the historical mean?

To calculate the consequences of a reversion to mean of corporate profitability, we must first make a few assumptions, as follows:

  • How long it takes for the mean reversion to be complete. I'll assume five years, which is close to historical norms, according to Montier. He says that, whenever the profit margin in the past has risen to be at least 1% above its mean, or fallen to be at least 1% below, it was back at its mean in an average of 4.8 years.
  • How fast the economy grows over the next five years. I will assume there will be no recession, which is very generous. But I'll do so in order to make my point. I'll assume that nominal GDP will grow over the next five years at the same pace it has since the last recession — 4.1% annualized.
  • Where the stock market's price/earnings ratio will be in five years' time. I will assume it stays at current levels, which once again is generous, since it is already above the long-term average today.

Once we make these assumptions, calculating the stock market's return over the next five years becomes a matter of simple math. The picture isn't pretty: Its five-year return, annualized, is minus 2.8%.

If so, the S&P 500 (.SPX) in the summer of 2019 would be trading at 1,703.

In fact, given the data, coming up with a rosy outlook for the next five years isn't easy. If we assume that corporate profit margins stay constant, for example, then the stock market's future growth will be the same as economic growth. That's 4.1% annualized on a nominal basis, given my generous assumptions.

Even a return to the record levels of corporate profitability above 10% of GDP won't produce anything like historically average stock market returns over the next five years. The only way for that to happen is for corporate profits to take an even bigger share of GDP in the future.

While anything is possible, that seems unlikely, according to Robert Arnott, chairman of Research Affiliates. For that to happen, the share of national income going to workers would have to shrink. In that event, Arnott says, "the backlash could be so widespread that it would turn Occupy Wall Street into a mainstream event."

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Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications and FICS-created content. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.
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