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One of Warren Buffet’s Favorite Metrics Is Flashing Red—a Sign That Corporate Profits Are Due for a Hit

Here's a crucial question for investors that the Wall Street crowd seldom addresses: Can corporate profits keep booming by growing faster than the economy? Is this the new normal, or will the GDP-gobbling trend reverse, as it always has in the past, turning today's record-shattering rally into a rout?

Shareholders beware. It's the unhinging of profits from the overall economy that has been propelling stock prices, and that dynamic is now in danger. Either the normal ebb and flow of markets will pull equity values back to their traditional share of GDP, or Congress is likely to do the job by attacking Big Tech and mandating that workers get a lot more of the bounty now flowing to shareholders. Either way, America's companies and its economy are one in the same. Over the long-term, they need to move in tandem. And if they stray too far apart, getting back to balance can pummel share prices.

The S&P 500's fantastic performance since late 2016 is all about earnings. Since the fourth quarter of that year, profits, based on the trailing twelves months of GAAP earnings, have jumped 41% to a blowout record of $134.39 per share. In that period, share prices have followed earnings like a postage stamp on a letter, rising precisely the same number to just over 3000. That's because investors are awarding shares a consistent P/E multiple in the 22 to 24 range.

But it's critical to assess whether or not a profit bubble has driven shares to unsustainably high prices.

To gauge if that's happened, let's examine one of the best measures of where stocks stand on the continuum from excessively cheap to dangerously expensive. It's the ratio of Total Market Cap (TMC), the value of all U.S. publicly traded companies, versus GDP, the value of all goods and services produced annually within our borders. Put simply, it shows the dollar size of the equity market as a share of the economy.

If the value of equities represents a far bigger than average share of national income, it probably means that epic earnings are devouring a much bigger share of national income than usual, leaving less for wages. That's certainly the case today. In the past, the gravitational force of competition for both goods and labor has always restored balance by curbing excessive profits, and in most cases, driving down stock prices.

The TMC to GDP ratio is a favorite yardstick of Warren Buffett, who's stated, that "it's probably the best measure of where valuations stand at any given moment." (We'll refer to the measure as the "cap ratio.")

Today, the value of all stocks to national income stands at 146.4. That's the second highest reading in the past half-century, exceeded only by the 148.5 posted at the peak of the dot.com bubble on March 30, 2000. The cap ratio has averaged around 80 over the past decade, so it now exceeds that benchmark by 80%.

The cap ratio has varied widely over the past five decades, but typically returns to that reading of 80 after spiking well above, and plunging far below, that mean. By definition, over each period the ratio starts and ends at 80, earnings simply grow with GDP. (We'll express GDP in 'nominal,' not inflation-adjusted terms.) Still, it's informative to study the careening course in between.

We'll start at the 80 mark reached at the start of 1971. The cap ratio fell as low as 35 in the deep 1982 recession, and generally stayed below 50 from 1976 to 1986. It didn't get back to 80 until the end of 1995, an interlude of 25 years. Over that period, the S&P 500 rose on average 7.3% a year, reflecting economic growth inflated by high inflation from the oil shock of the 1970s and early 1980s.

From that 80 reading at the end of 1995, through March 30 of 2000, the cap ratio went wild, jumping 86% to that record level of almost 150 at the height of the internet craze. Then, gravity took over, and by April of 2003, the "cap" had crashed back to 80. Over that 7-plus year period, the S&P 500 rose by a more or less normal 5.6%, half as fast as in the past half-decade, once again, tracking GDP.

From the 80 reading in early 2003, the ratio plunged to the low 50s during the 2009 financial crisis, and didn't hit 80 again until October of 2011. Over those seven-and-a-half years, the S&P gained just 3.1% annually, as cratering home prices hobbled the economy.

Since returning to a "normal" level in late 2011, the cap ratio soared hockey-stick style, hitting the current 146.2 while suffering only minor blips along the way. Over those 7 years and 9 months, GDP rose 35%, from $15.6 trillion to $21.1 trillion. Total market cap leaped from $12.6 trillion to $30.14 trillion, or 148%. The S&P 500 delivered annual gains of 11%, while national income rose less than half as fast, by 4%.

Put simply, companies cut back on workers, held down wages, feasted from low interest rates on their debt, and otherwise benefited from a perfect calm for profits. And those trends totally trumped mediocre economic growth.

Two additional measures are flashing red. I often interviewed Milton Friedman, the legendary economist, before his death in 2006. Friedman told me that "in the long term, earnings cannot remain above their historical average as a share of national income." The Nobel laureate also declared that although profit performance determines companies' values over lengthy periods, "markets in the short term are far from 'efficient,'" meaning that equity prices can vary significantly from the enterprises' underlying value.

Today, according to the St. Louis Federal Reserve, corporate profits account for 9.2% of GDP. That's one-third higher than the half-century average of 7%. Since profits normally "revert to the mean" a la Friedman, that gap is destined to shrink. Operating margins also look unsustainably high. According to S&P, the figure for the S&P 500 averaged 11.25% over the past four quarters, 25% above the average of 9% posted in the previous 30 quarters.

It's conceivable that our economy really has changed, as the break-up-tech crowd in Congress argues, and that internet is enabling tech giants to operate as monopolies. That's the position adopted by a number of influential economists, including former Treasury Secretary Larry Summers. Another possibility: Because they're so profitable, these players are prime targets by hungry startups that will eventually erode their profitability.

The best bet is that equity valuations return to a more normal share of national income. The past few years look like the kind of crazy uncoupling that happens every couple of decades, not a structural downshift from the world's most competitive market to a network of cartels.

The market hasn't failed to rein in runaway profits yet, and it won't fail this time.

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