“Let’s say a company has $10 in sales and earns one dollar,” says associate editor Ralph by way of example. “We would say that the company has a 10% net profit margin. But what’s really important is how much capital it took to generate that dollar.”
“Take two businesses. One has equity invested of $5, and the other has $15. Neither has any debt. Both generate $10 in sales and both generate $1 in profits, for a 10% profit margin.”
“But the return on equity (ROE) of the first business is better, at 20% ($1 divided by $5) compared with the second, which is 6.7% ($1 divided by $15). So you see that the profit margin itself tells only part of the story. All other things being equal, the market pays up for the higher ROE.”
With that in mind, witness the return on equity for the market as a whole, both for the U.S. and for the world. “It’s been rising as if shot out of a cannon,” says Ralph.
“It’s not a perfect indicator,” our plucky and stocky office drone hastens to point out. “The market peaked in March 2000, well ahead of the peak in ROEs. The market also bottomed ahead of the bottom in ROEs.”
“But the scary part of the chart is where we are now. In January 2012, we sat at a peak not seen since the 2000 peak. We are way above the long-term average.”
Ralph says there are three ways to drive ROE higher: “You can take on debt, you can raise profit margins or you can increase your asset efficiency (do more with fewer assets). In the U.S., it’s the latter two that drove ROE higher lately. But it certainly will be tougher to make similar gains in 2012 — especially with the macro risks hanging out there.” Like Europe.
“I think it is safe to say it is unlikely that ROEs can climb much further or for much longer. It seems unlikely they can stay here for very long.”
“The S&P 500 is likely to be in play over the next two weeks,” warns our monitor of market sentiment.
He’s been eyeing the S&P relative to the Bloomberg Financial Conditions Index. The BFCI monitors stress in the U.S. markets. It tracks money market spreads, bond market spreads and assorted stock market indicators... and how far they deviate from historical norms.
Here they are plotted together on a chart. “Pay special attention,” says Ralph, “to the huge spike down in the middle. That’s the financial collapse in September 2008.”
“As you can see, for the most part, there is a close co-movement. What’s interesting is when it diverges from being a coincident indicator.”
“Right after the ’08 collapse, the S&P 500 actually lagged the BFCI. This showed the market sentiment was oversold or too pessimistic.”
“This time we are seeing something very different. The S&P 500 is probing resistance levels, but the BFCI is not. This indicates that the crowd’s sentiment is too optimistic — or at least is not being confirmed by financial conditions.
“The takeaway from this divergence is that the S&P 500 price action is not sustainable. In other words, get ready for a change in expectations.”