One reason to be cautious: very high corporate profit margins

There are many reasons to be cautious these days. Issues such as the fiscal problems in Greece are blown out of proportion and largely irrelevant in the long run IMO. Similarly, although it has resulted in irreparable harm to the environment, the Gulf oil spill is likely to have very little on the economy. Those in the impacted regions will feel it but I doubt it will even shrink US GDP by 0.5%.

However, there are other reasons to be really cautious right now. One such reason has to do with the high corporate profit margins over the last decade. I think I brought up this point since the early days of this blog, almost 3 years ago, but the situation hasn't changed. Bloomberg quoted the bearish outlook of Smithers & Co and produced the following chart (h/t Naked Capitalism):

I have never encountered the measure of profit margin that is used here—I am more familiar with the more popular pre-tax corporate profits as a percentage of GDP. According to Bloomberg, this measure uses a ratio of profits before interest, taxes, and depreciation to US corporate output. I'm not sure what "corporate output" refers to. In any case, I don't think the picture detracts from the main point. The corporate profit margin measure I am familiar with also produces a similar graph, except it isn't as extreme.

One take-away from this analysis is that corporate profit margins are really high right now. The measure used in this chart indicates that profit margins are the highest in 60 years—the post-war period. I don't know if you share the same feeling but, when I first looked at charts like these, I found it remarkable that earnings growth in the 2000's was even higher than the booming 90's. Partly the reason is because of fictitious earnings in 2000's (particularly from the financial and real-estate sectors) but that doesn't explain it all. I neither have the time nor interest right now but I should read up on the 90's and see why earnings growth wasn't as high as the 2000's. A bigger share of growth clearly went to workers, whereas it didn't in the 2000's, but that can't be the full story. Even more remarkable was how the market was bidding up certain industries, like dot-coms (e.g. Yahoo), growth (e.g. Pfizer, Wal-mart), telecom (e.g. Nortel, Lucent), while overall corporate profitability wasn't that high.

Smithers expects near-term results to fall short of analyst expectations. According to Bloomberg, analyst forecasts for earnings growth for S&P 500 this year is 34% and 18% next year. My guess is that earnings may hit this year's target, simply because it is coming off a low base and high government stimulus; but I suspect earnings will come up short next year (long-term earnings growth is around 10% if I recall correctly, and analysts are expecting almost double at 18%.)


The key point for macro-oriented investors, though, is not that the current profitability is high. Rather, it is more important to note that the profitability was high all throughout the late 2000's. Investors like me who simply take average historical earnings and apply a P/E multiple need to be really careful. The earnings in the 2000's, particularly the last 5 years, is likely to be abnormally high. It probably isn't just the bubbly sectors like financials, real-estate, and commodities. I suspect profits across almost all industries are likely to be unsustainable.

I have a feeling that we may have witnessed a multi-decade peak in profitability (i.e. earnings growth.) If I remember correctly from my reading of the Anatomy of the Bear, a major peak in profitability set in 1918 (due to World War I) was not broken until the 1940's or something like that—even the Roaring 20's did not break that from what I recall! I have a feeling we may have seen something similar. If so, I think macro investors should spend their time thinking about what sectors will see profitability "reversion to the mean" so to speak, and which ones won't. The biggest danger probably lies with commodity businesses, simply because their earnings growth in the last decade has been spectacular.