Back at the height of the dot com bubble in 1999 Warren Buffett said; “You have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.”
Due to extended ultra-low borrowing costs, low wage growth and cost-cutting measures, corporate profits have been holding at almost twice that level as corporate profits after tax have risen above 10%.
While this is great news for investors, as evidenced by the large gains in the market, keep in mind that profit margins have always reverted to the mean.
This reversion may already be taking place. Profit margins showed a significant year over year decline of .6%. This decline is notable as recognized by Barclays’ Jonathan Glionna in a note to clients. “The link between profit margins and recessions is strong.” “We analyze the link between profit margins and recessions for the last seven business cycles, dating back to 1973. The results are not encouraging for the economy or the market. In every period except one, a 0.6% decline in margins in 12 months coincided with a recession.”
The one time it didn’t coincide was in 1985 when the decline was due to the energy sector which is the same situation as we have today. At that time however we didn’t have the heavy QE influence and ultra-low rates seen today.
It remains to be seen if this profit margin decline will continue which is why it’s important to keep an eye on corporate profit margins outside of the energy sector. As earnings season begins in earnest this week, we’ll be watching for any signs of further weakness and earnings guidance for 2016 very closely. Expectations are for earnings to decline for the second straight quarter which hasn’t happened since 1999.
It’s hard to fathom a scenario in which profit margins would be able to hold at their current lofty levels. As wages start to gradually increase, borrowing costs slowly start to rise and additional cost cutting measures become more difficult to come by, profit margins should continue to revert to the mean as they always have; which, along with reduced corporate stock buybacks will have a negative impact on earnings and P/E ratios