GMO What Goes Up Must Go Down
GMO
WHITE PAPER
March 2012
What Goes Up Must Come Down!
James Montier
A Little Detour into My Murky Past
Nearly a quarter of a century ago, I was a young, naïve, and foolish believer in an economic concept known as rational expectations – an elegant, mathematically beautiful theory with no practical use. In Star Wars parlance, I had effectively been seduced by the dark side. Thankfully, several of my university lecturers were determined to save me from this terrible fate. They insisted on teaching me a very wide variety of approaches to economics including the
Marxist perspective and the something known as post-Keynesian macro. I owe them a huge debt of gratitude.
I thought at the time that these were at best esoteric distractions. Little did I know that they were going to provide some of the most profound insights into financial markets, illuminating many of the flaws that conventional thinking ignores. Early on in my career I was fortunate enough to interact with a number of colleagues who used some of these tools to uncover observations that the mainstream had completely missed. This made an indelible impression upon me, and these tools are still the ones I reach for when faced with trying to understand the world.1
Profit Margins as a Case in Point
Today I find myself once again digging through this toolkit, searching for a way to understand the development of profit margins. Currently, U.S. profit margins are at record highs according to the NIPA data (see Exhibit 1). More freakish still is that these record high profit margins are coming during the weakest economic recovery in post-war history.
At GMO, we are firm believers in mean reversion, and as such record elevation in profit margins causes us much consternation. Of course, we are constantly on the lookout for sound arguments as to why we might be wrong in our assumption of margin reversion. After all, believers in mean reversion are always short a structural break, and such a break clearly matters. For
WHITE PAPER
March 2012
What Goes Up Must Come Down!
James Montier
A Little Detour into My Murky Past
Nearly a quarter of a century ago, I was a young, naïve, and foolish believer in an economic concept known as rational expectations – an elegant, mathematically beautiful theory with no practical use. In Star Wars parlance, I had effectively been seduced by the dark side. Thankfully, several of my university lecturers were determined to save me from this terrible fate. They insisted on teaching me a very wide variety of approaches to economics including the
Marxist perspective and the something known as post-Keynesian macro. I owe them a huge debt of gratitude.
I thought at the time that these were at best esoteric distractions. Little did I know that they were going to provide some of the most profound insights into financial markets, illuminating many of the flaws that conventional thinking ignores. Early on in my career I was fortunate enough to interact with a number of colleagues who used some of these tools to uncover observations that the mainstream had completely missed. This made an indelible impression upon me, and these tools are still the ones I reach for when faced with trying to understand the world.1
Profit Margins as a Case in Point
Today I find myself once again digging through this toolkit, searching for a way to understand the development of profit margins. Currently, U.S. profit margins are at record highs according to the NIPA data (see Exhibit 1). More freakish still is that these record high profit margins are coming during the weakest economic recovery in post-war history.
At GMO, we are firm believers in mean reversion, and as such record elevation in profit margins causes us much consternation. Of course, we are constantly on the lookout for sound arguments as to why we might be wrong in our assumption of margin reversion. After all, believers in mean reversion are always short a structural break, and such a break clearly matters. For