http://www.wyattresearch.com/article/can-profit-margins-stay-strong/23338
Can Profit Margins Stay Strong?
Ian Wyatt | The Daily Profit | June 10, 2011 2:10pm EDT
The S&P 500 is about to conclude its 6th straight week of declines. Amazingly, there haven’t been 6 straight down weeks since 2002. Even the financial crisis didn’t give us that many consecutive weeks with losses.
Of course, the losses came a lot swifter in 2008 and 2009. So far, this correction has only taken around 70 points off the S&P 500. That’s around 5.5%.
But there are some interesting observations to be made about the decline. First and foremost, it has been orderly. A slow bleed lower, if you will, that is very similar to the slow bleed higher that characterized the QE2 rally from August to the end of April.
There hasn’t been any real panic, no “sky is falling” sell-offs. Just a steady decline of stock prices.
To me, this action smacks of automated, institutional selling. Mutual funds, hedge funds and pension funds are adjusting their portfolios for slower growth, with the potential for lower profit margins. They are not simply dumping stock in a mad rush for the exits.
*****Right now, analyst earnings estimates imply 9.8% profit growth in 2012, according to the Financial Times. The S&P 500 is trading with a forward P/E of 13, according to the Wall Street Journal.
Now, we can read this in two ways. We could say that, based on estimates, the S&P 500 is relatively cheap. Or we could say that there is skepticism that earnings expectations will be accurate.
Given the recent declines, weak growth, and lowered growth estimates, it would seem prudent to be a little skeptical of earnings estimates. Historically, the mean for profit margins is 6.5%. But of course, margins have been running much better than that for several quarters.
What’s more, the bearish view that companies will not be able to maintain profit margin growth has thus far consistently been proved wrong.
Does that mean margins can continue to grow? Of course not. Trees don’t grow to the sky.
*****Now it’s all well and good to say that profit margins can’t grow forever and because the economic recovery has slowed, margins will revert to their mean. It’s quite another thing to assume this means that corporate profits and margins will be lower when companies start to report in another few weeks (Alcoa (NYSE:AA) reports 2Q earnings July 11).
We’ve clearly seen that companies have adjusted production to meet demand. And on top of that, productivity has surged, meaning that companies are getting more output from their employees. That’s why margins are so strong.
As we have clearly seen from recent employment statistics, companies are not adding new workers at a very fast pace. Since labor is a company’s biggest expense, we can assume that costs are not rising quickly enough to impact margins. I would argue that even the rise in commodity costs are not enough to seriously impact margins.
That leaves us with the consumer spending. Are current consumer spending levels sustainable?
Consumer spending is expected to be up 2.1% this quarter, once the final tally is made. And it’s expected to rise to near 3% for the second half of the year. For all the fear that recent employment numbers have created, it seems to me that the consumer is chugging along pretty good.
*****Let’s also not lose sight of the probability that some of the current weakness in the stock market is related to positioning for the end of QE2. The stock market is always forward-looking, and traders and investors will make their moves before the end of the Fed’s stimulus program.
It may seem ironic to target the end of QE2 on June 20 as the end of a market sell-off and start of a rally, but the stock market always seems to enjoy irony.
*****One thing that seems certain, the record $9 trillion in cash sitting on corporate balance sheets isn’t going to disappear. Even if profit margins decline, dividend payments will, at worse, remain steady. And they may even rise as companies become more committed to rewarding their shareholders.
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