The Ignorant Investor

Interesting chart from the St. Louis Federal Reserve, showing the divergence between P/E ratios and the S&P 500.





What it shows is that even though the market is now less optimistic about the future (and thus unwilling to support high valuations), corporate America has spent the past couple of years marking up record profits. Globalization has allowed them to find a sweet spot where consumers flush with cash from rising asset prices buy products made by low-wage workers in developing economies. The result? The companies have lowered their expenses while charging the same prices, and that has kicked profits into the stratosphere without triggering high inflation. It's only in the cost of materials that we've seen inflation- oil, metals, wood- because the supply of these isn't currently as ample as that of cheap labor.

If these record high profits prove ephemeral- if, for example, labor costs in developing economies started to rise, or consumers run out of cash to spend- we should expect to see the traditional linkage between multiple contraction and falling stock prices reassert itself. Probably quite rapidly.