Big Market Worries: Profit Margins
Often there is a persuasive argument, apparently supported by data, that can be misleading for the long-term investor. Sometimes this relates simply to facts, but it can also involve analysis. Such is the case with what you see about profit margins.
The basic thesis is that profit margins are mean reverting. If any company gets an excessive margin, competition will arise and bring the profits to a more normal level. This is a persuasive argument, consistent with how we expect capitalistic economies to work.
Let us suppose that we agree that profit margins will return to long-term norms. (Good here!)
What are the implications?
The Bearish Viewpoint
Those with a bearish perspective take current revenues and do what they refer to as "normalizing" to chop the earnings down to lower levels. If you reduce S&P 500 earnings by 30% or so, you can easily conclude that most stocks (and the market as a whole) is richly valued.
I do not want to give this viewpoint short shrift, but it gets a lot of visibility, and the basic contention is simple.
The Bullish Viewpoint
First Trust's Brian Wesbury raises a sharply contrasting argument:
Yes, the Fed is loose and is holding interest rates down artificially. But even if we assume more normal interest rates and stable profits (with implies declining margins), stocks are very cheap. Cheap enough in our view to take us to 14,500 on the Dow and 1475 on the S&P 500 by year end 2012.
Using a capitalized-profits approach, we divide corporate profits by the current 10-year Treasury yield of 2% and then compare the current level of this index from each quarter for the past 60 years. Hold on to your hats…this method estimates a fair-value for the Dow at 46,000. But, this extremely bullish result is largely due to artificially low interest rates. Current levels on inflation are above the 10-year Treasury yield and we believe that once the Fed normalizes its policy stance interest rates will climb to much higher levels.
If we use a more realistic discount rate of 5% for the 10-year Treasury, we get a fair value of 18,800 on the Dow and 1,975 for the S&P 500.
Another potential problem is that profits have been an unusually large share of GDP – currently almost 13%. If profits revert to a historical norm of about 9.5% of GDP at the same time the 10-year Treasury yield is 5%, fair value would be 13,900 for the Dow and 1460 for the S&P 500. Just to be clear, that would be in a world where profits fall roughly 25% and interest rates more than double from their current levels. In other words, this doesn’t look like a dead cat bounce to us.
Our Conclusion
Let's face it. The argument about mean reversion in profits is several years old. Profits keep rising and margins have held up pretty well, mostly because companies have been slow to bring back employees. The P/E multiple declines, partly because the world is full of skeptics about future profits.
The leading advocate of profit mean reversion is Vitaliy N. Katsenelson. I did a favorable review of his excellent book, which has excellent advice on stock picking. A book about a sideways market is a coup on many fronts, and I enjoyed reading it.
Unfortunately, many investors are convinced from these arguments that profits are about to decline. This conclusion is not supported by the data.
High profit margins came when companies held down costs and new hiring. If the margins fall, it implies that new workers have been added. That is the basis for additional costs. This means that employment, GDP, and tax revenue are all moving higher.
Briefly put – Those who look at mean reversion in profits alone, without any attention to changes in employment, are guilty of an inconsistent forecast.
I have a simple challenge for those forecasting a mean reversion in profits: Do you really expect the overall S&P earnings forecast to move lower?
If not, why should we care about profit margins?
Here’s my argument for margins not being mean reverting (at least for an individual company). High margins allow the company to hire the best talent, making it unavailable to their competitors. They can demand and get the best product placement for retail sales. Purchase orders go there because of reputation. These companies used to be called monopolies, and they are very hard to break. I might be wrong, but we sure seem to have a bunch of them right now.
Jeff, good article.
I looked at the S&P earnings decline in the last few recessions because I though the 30% decline assumption seemed excessive.
Interestingly, the S&P earnings decline in a recession seem to be getting bigger over time. Earnings fell 10% in 1970, 18% in 1975, 13% peak to trough in 1983,
21% between 1989 and 1991, and 30% in both 2001 and 2006-09.
Jeff, I know inflation was an issue for the numbers from the 1970’s but what do you attribute the larger declines in recent years? Higher corp debt levels?
Is this trend just a fluke? Or, does it mean that missing a recession call has a greater downside risk than 20 years ago?
Proteus — There is merit in your argument. I am trying to look at the most conservative case.
Meanwhile I am finding companies like those you name.
Good points….
Jeff
Angel — I have been thinking about this and I have an article on the agenda.
My preliminary conclusion is that the 2000-era recessions were greater and therefore had a bigger effect on earnings forecasts.
A corollary question is whether earnings forecasts should incorporate the chance of a recession. For a one-year period? For a five-year period?
The answer should be different.
Good question and my answer is only preliminary.
Jeff
Jeff – – –
A week ago Steve Hansen posted an article about the latest PPI data: http://econintersect.com/wordpress/?p=19345
He has been following the decline in PPI over recent months. There are two relevant factors to your discussion:
1. PPI has been declining toward the CPI number. It’s still higher (ca. 4%) but was much higher several months ago.
2. The Crude goods PPI has been very much higher than the finished goods number for the past year but has now come down almost to the same level.
These two events are indicating less margin pressure for finished goods producers and should help earnings improve in those sectors.
I am a mean reversion advocate, simply because I do not believe the business cycle has been overturned. However, there are some things happening right now which may mean that the next business cycle dip may not be quite here yet, ECRI’s stubborn prediction notwithstanding (and John Hussman and others as well).
I believe your discussion is very timely.
What might be more relevant to the conversation is to consider what drives corporate profits (revenues, cost of goods, operating leverage, interest/financial leverage, taxes) and whether the tailwinds from these sources have been totally tapped out. In some cases, the answer is “likely”, in other cases, the “likely” answer is debatable.
In reality, profit cycles have the ability to last longer than one thinks– mainly because there are a lot of levers firms can pull to drive things higher in the right conditions (like now). And those that can gain market share at the expense of others (think Apple vs. HPQ), can keep the profit engines going while gaining a greater share of the market cap pie.
Do profits mean revert? Sure– they revert with the business cycle in aggregate. But because each business cycle is different, the slope of that mean over time can shift as well.
In the 2000-02 recession period, you’d be surprised to discover that the magnitude of economic decline didn’t come close to matching the decline in profits, and the resulting multiple compression. One could rationally argue that outsized premiums were being placed in peak profits during that time.
By comparison, the premiums placed on the profits already earned might make this market appear relatively cheap. I don’t think it’s a stretch to argue, though, that the underlying sources of these profits (save the exceptions of labor/capital utilization) are becoming scarce. If one can reignite that cap utilization fuse, then this discussion on profit cycles reverting anytime soon becomes somewhat moot.
Jeff,
Wesbury is a permabull and terminally infected by his political views. I wince on those occasions where you cite his authority on anything.
On the margin subject, like Assetman above, I’d like to see some discussion about where the margins are coming from – operating numbers, for example, or the tax line. I suspect the tax department at MNCs have been helping to trend margins for the better for many years now, but I’d suggest those aren’t high-quality numbers and don’t deserve a high capitalization.
I am generally unconvinced of the “it’s different this time” arguments offered by the margin bulls. Margins will revert to something lower, it’s just a matter of when. It’s probable though, absent a recession, that overall profits remain stable, with higher volumes offsetting lower margins.