Swedroe: A Look At Record Profit Margins

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

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.

Second, the recession and the slow recovery, along with the Fed’s program of zero interest rates on short-term rates as well as bond buying at the longer end of the yield curve has allowed many companies to refinance debt at much lower rates, with a positive impact on profit margins.

It’s also important to note that today 80 percent of corporate liabilities are long-term debt. In 1996, when we weren’t in a recession and were at average margin levels, only 50 percent of corporate debt was long-term. With firms having locked in low interest rates for the long term, even if interest rates rise, their exposure is relatively small.

Third, companies are now sitting on more than $1.6 trillion in cash, a record amount. That not only helps margins because companies don’t have the interest expense on debt, but if rates were to rise, companies will be earning higher rates on that cash horde.

Fourth, with the large amount of slack still in the labor force it seems likely that pressure on wages, which could lead to narrowing of margins, is unlikely to be an issue for a long time. Margins typically come under pressure at or near the peak of the business cycle when labor is in short supply and it can demand a greater share of national income.

Fifth, if we look at corporate profits as a percent of gross domestic income, while they’re at a 40-year high of about 10 percent, their share was even higher for much of the period from 1950 through the late 1960s.

Finally, it’s important to remember that since I’m aware of these facts, and the risks, it’s safe to assume that “the market” is also aware of them. Thus, the risks are already embedded in prices. Trying to time the market based on your belief that you’re a better judge of the data is a loser’s game, just like the games in Las Vegas—it’s possible to win, but it’s so unlikely that the surest way to win is to not play.

The bottom line is that there are always risks in the stock market, and there are always things to be worried about. But focusing on them is the wrong strategy because most of the market’s returns are determined by surprises, which, by definition, are unpredictable.

And because happy surprises are as likely as unhappy ones, returns take what’s called a “random walk.”

Thus, the winning strategy is not to focus on the current news, or some guru’s forecast. Instead, it’s to focus on what you actually can control, the amount of risk you take, which risks you take, diversifying the risks you take as much as possible, keeping costs low and tax efficiency high.

The best way to do that is to have a well-thought-out and -documented investment plan, including an asset allocation and rebalancing table—signed and adhered to.

Larry Swedroe is a director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.