Swedroe: A Look At Record Profit Margins

May 23, 2014

Investors looking at record S&P 500 Index profit margins should think hard before worrying.


It’s not as if investors didn’t already have enough to worry about in the uneven aftermath of the financial crisis. Now, money pundits are crowing that record profit margins might soon pose a problem in markets.

Some of the worries coursing through the markets these days include:

  • A dysfunctional Congress’s failure to address the long-term structural deficits in the entitlement programs as well as creating a threat of a default on Treasury debt
  • Equity valuations are at high levels, with the Shiller CAPE 10 (cyclically adjusted price-to-earnings ratio) at about 25
  • The risk of inflation caused by the explosion in the Federal Reserve’s balance sheet
  • The tapering of the Fed’s program of quantitative easing and the uncertainty that creates for the bond market
  • The economic uncertainties created by the problems with the Affordable Care Act
  • And, not least, the threat of a nuclear Iran

Now corporate profit margins can be added to the list?

You’re probably thinking that record profit margins are a good thing. The companies within the S&P 500 Index reported operating margins of 9.5 percent for the quarter ending June 2013. That was just short of the 20-year high of 9.6 percent reached in the third quarter of 2006. Today the figure is at about 10 percent.

The problem is that profit margins in the past have exhibited a strong historical tendency to “revert to the mean”—above-average margins have tended to fall and below-average margins have tended to rise. According to U.S. Commerce data, the average profit margin since 1952 is about 6 percent.

Clearly, if profit margins reverted to their mean, even if the process took several years, unless sales growth increased rapidly and/or price-to-earnings ratios rose to offset the drop in margins, the stock market could take a sharp hit.

And that begs the question, Should you be worried?

While my crystal ball is always cloudy, there are some reasons that suggest the concerns are overstated.

First, as the U.S. share of the global economy shrinks, more and more of the profits of U.S. companies are coming from overseas, where corporate tax rates are much lower. Thus, part of the explanation for the higher margins is a lower effective tax rate.

It’s worth noting that except for the two-year period covering the fourth quarter of 2007 through the fourth quarter of 2009—the period of the financial crisis—margins have been above 8 percent since the third quarter of 2003.



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