Corporate profits: Not as good as they seem
FORTUNE — Over the past year or so, corporate profits have been a growing concern for investors. They’re too good.
Margins, the percentage of each sale that ends up as profit, as measured by GDP, have never been this high. They hit a record near the beginning of 2011 and have continued to march up. At the end of June, corporate profit margins were 11.5%. That’s two percentage points higher than the roughly 9.5% they peaked at in 2006.
As a result, the general conclusion is there is nowhere for profit margins to go but down. That’s bad news at a time when the economy is growing so slowly. Even if the economy continues to improve, companies, after years of cost-cutting — a main reason why margins are so high — will have to hire. Actual profits are sure to fall.
But strategist and economist Ed Yardeni thinks profit margins, at least the ones that matter most to the market, may not be as high as everyone assumes. He says that while overall profit margins are the highest they have ever been, the profit margins of the companies in the S&P 500 (SPX) are not that out of line from other economic rebounds.
The average after-tax profit margin of the companies in the index was 8.5% at the end of the June. That’s below the 9.5% they hit in early 2007. What’s more, profit margins for the S&P actually fell last year, and that didn’t seem to upset the market. Stocks were still up over 12% in 2012, and another 19% this year as well, though margins have been climbing again.
There are two points to be made here. The big economic one is that the split between the two profit measures suggests the biggest margin gains of the last few year have been coming more from small companies and not from the giant ones in the S&P 500 index. The conventional wisdom is that profit margins are up because companies are moving jobs overseas, cutting labor costs, and avoiding taxes. Smaller companies tend to improve their margins because of innovation and technological gains. Over the long haul that’s better for the economy, even if it still means fewer jobs now.
The second point is that while profit margins, at least for the big companies that matter most to the market, are high, they’re not historically high. In fact, they are not at the point at which they are unsustainable, which is what everyone is worried about. Profit margins could stay high for a while. James Paulsen of Wells Capital Management says the real thing that will kill profits is inflation, which has been low, and is likely to stay low as long as the economy remains weak.
If the economy does pick up, then profit margins may indeed fall, but by then sales will be rising faster, and that will boost corporate bottom lines. Profit margins might not matter as much.
“Margins are high and likely to come down,” says Paulsen. “I just don’t think that means we are entering a bear market.”