Many people – but especially the bears – have argued that profit margins are mean reverting, and so the current high levels of profit margins are bearish for future earnings, and hence equity prices. There is already a TON of literature out there on this topic, but one of the best is this post from Philosophical Economics:
I won’t go over all the different points there, so if any readers not familiar with the background material should just check out that post. The concluding point is that, properly measured, the net profit margin of domestic corporate businesses is quite high:
I want to make the point that this actually makes sense – and furthermore, the trend is likely to continue.
Let’s first go through a thought experiment. Let’s say that sales growth in industry A is 10% a year, while sales growth in industry B is 3%. Which industry’s profit margins do you think will be higher?
To me, a major reason for falling profit margins is the prevalence of competition. More competition = lower margins, as incumbents struggle to fight off new entrants. Well in that scenario, which industry do you think are likely to have more new entrants, A or B?
I think this all makes sense, and in addition, I think the data bears this out. The chart below shows the rolling 10y average nominal GDP growth, (which is a proxy for national sales growth) inverted. Then take a look at the chart of profit margins above. See a relationship?
To me, I think the data is clear. Lower sales growth (proxied by nominal GDP growth) reduces the number of new entrants and allows profit margins to stay elevated. And with potential growth estimates still falling, (as estimated by the bond market, the Fed, and consensus) 5 years after the recession, prospects for a return to higher NGDP growth, and hence lower profit margins, seem quite low.
Anyway, I recognize that this is all starting me make me sound like a perma-bull, but I think there are some really strong secular stories here that are not well understood or priced in by the markets. It is quite popular to say, “this time is not different!” But that view precludes the possibility that the interpretation of previous episodes were incorrect.
- UK PMI improved to 57.3 vs 55.4 exp and 55.3 prev
- US Jobless Claims jumped to 344k last week vs 320k exp and 329k prev. Easter related seasonality likely played a role
- Core PCE rose to 1.1% as exp vs 0.9% prev
- ISM Mfg jumped to 54.9 vs 54.3 exp and 53.7 prev
- Fri: ItalyPMI, US Employment, China Non-mfg PMI,
- Mon: AustraliaBuilding Approvals, China HSBC Mfg PMI, ISM Non-Mfg PMI, AU Trade Balance
- Tue: RBA, EU Services PMI, NZ Unemployment, Australia Retail Sales, China HSBC Services PMI
- Wed : UK RICS House price balance, Australia Employment
- Thu : BoE, ECB, Canada Housing Starts, US Jobless Claims, RBA Minutes
- Fri :