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What goes up must come down

"What goes up must come down" was true with dot-com stocks and the residential housing market. The same dynamic is at work with corporate profits, argues James Montier of the investment management firm GMO in an intriguing report.

"Currently, U.S. profit margins are at record highs according to the NIPA data," he writes. "More freakish still is that these record high profit margins are coming during the weakest economic recovery in post-war history." (NIPA stands for National Income and Product Accounts, a major data source on the economy.)

Montier goes through a set of basic economic calculations to look at what has been driving those "freakish" corporate profits. I'll spare you the details -- although I recommend reading the eight-page paper -- and go right to the bottom line: government spending or the huge federal deficits. 

He believes profit margins will come down as the deficit comes down in future years, a force for a less optimistic long-term stock market outlook.

What might take the government's place? He runs through the main alternatives and doesn't see much to get excited about. Stock investors should cool down their expectations about the future.

Corporate investment may increase slightly from today's levels, but to really surge would require a strong economic recovery and the return of Keynes's infamous animal spirits. Leading economic indicators don't suggest that this is currently on the horizon. Likewise, the housing starts data suggests that housing investment is likely to be essentially flat.

The government deficit may stay high this year, due largely to it being an election year. However, it is almost unthinkable that it will remain at current levels over the course of the next few years. As such, unless households start to re-leverage or the current account improves significantly, and assuming that the government moves toward some form of deficit reduction plan, corporate profits are likely to struggle.

Profit margins certainly can't stay "freakishly" high. Markets, trees and profits don't climb upward forever. However, I am more optimistic about the outlook for corporate investment and especially a return of the animal spirits of capitalism.  

About the author

Chris Farrell is the economics editor of Marketplace Money.

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