Profit Margins, Down To Earth?

One of my good friends who runs a small investment boutique pointed me towards today’s chart of the day from Bloomberg showing the flight phoenix of US corporates’ profit margins.

I know that the chart is difficult to read but you only really need to look at the trend and thus the fact that profit margins recently have defied gravity. However, the old tale of Icarus may turn out to be cautionary here and the coverage by Bloomberg (and the reason my friend put it forward) also flags the fact that the current level of corporate margins essentially is a lagging indicators of things in the past and the real issue is that profit margins tend to be mean reverting over time.

Profit margins for U.S. companies are likely to tumble from last quarter’s record, a decline that will lead to much lower earnings than analysts expect, according to economist Andrew Smithers. “The corporate sector’s outlook is extremely bad,” Smithers, founder and chairman of the investment-advisory firm of Smithers & Co., said last week in an interview. “I can’t see any way out of it.”

As the CHART OF THE DAY shows, profit before interest, taxes and depreciation — accounting adjustments for wear and tear on buildings and equipment — amounted to 36.4 percent of U.S. corporate output in the first quarter. The calculation was based on data compiled by the Commerce Department. The percentage was the highest since the department’s quarterly data started in 1947, as the chart depicts. Smithers, whose firm counsels more than 100 clients on international asset allocation, included a similar illustration in a June 18 report.

So, what is the problem here? Well it makes sense if you think a little about it that profit margins might be in for a correction since much of the gain in the past 1 1/2 years has been due to cost cutting. Market pundits have had this debate before as stock markets soared in 2009 while unemployment kept on climbing. In this sense, the underlying point is quite simple. The first leg of the recovery for corporates (and thus in some sense their stock value) came through trimming the cost side and now, the second leg should start to kick in in the form of increasing final demand to beef up margins, but If the underlying demand is not there, well; herein lies the rub.

In this way, it was always going to be an issue as to where final demand would come from once government stepped back its spending binge and companies had exhausted their initial trimmings on the cost side. As such, we are only now returning to "normal" where we will see what the cruising speed of our economies (in this case the US economy) really is and what Mr. Smithers really points to here is that this implies a much slimmer margin on earnings and thus, strictu sensu, a lower stock price. Personally, I don’t expect a double-dip in the US in 2010, but there might well be one in 2011 which would square off nicely with the points made above. The meta theme I am working with here is that we are going to experience lower trend growth and higher volatility of growth going forward which, by definition, means more frequent moves into negative territory. Coming back to the issue of mean reverting profit margins, my friend makes the following remark;

I think the process has to do with the fact that companies did slash costs right away, faster than selling prices. Now reality catches up. Either final demand does not recover enough and companies are forced to lower prices and compete with little further room for cost cutting or demand recovers and companies have to replenish part of their cost.

Now, based on this argument and coming back to the main rule of thumb, profit margins should start to trend down on mean reverting alone and this remains a very strong empirical fact to think about in this context. Recently, Edward Harrison made a similar point worth pointing out in the context of a slowdown or perhaps even a recession in 2011.

Long-story short: high margins mean-revert as do P/E ratios. That means share prices will be doubly under pressure in the next recession. Moreover, with households also likely to pull back given still high debt levels, there is a lot of downside for shares going into that downturn which I believe could begin as early as 2011.

Not very comforting this and as a final perspective on this topic I thought that I would mention a recent report by Fitch (login required) in which the rating agency is much less sanguine about a record low high yield default rate in 2010 attributing it to much of the same reasons above.

Fitch Ratings finds that fundamental and rating trends support the contraction in defaults, but the extent to which defaults have fallen is also a product of other dynamics. These include the timing of the recession’s impact on corporate credit quality; the strong demand for yield product in a low interest rate environment which has greatly benefited corporate borrowers seeking to refinance debt; and the deliberate and quick action on the part of U.S. companies to cut costs and boost liquidity in response to the downturn and deep fears of a prolonged period of sluggish growth.

The perspective from credit markets is interesting since it remains one transmission through which mean reversion of profit margins would materialize. In the end then, it seems that while profit margins for now may be defying gravity they, like the proverbial, apple will eventually come down to earth with a corresponding effect on stock prices.