Gadfly

Standing at the Margin Peak, the Only Stock Direction Is Down

If investors don’t think profits are sustainable, a sell-off is inevitable.

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Photographer: Prakash Mathema/AFP/Getty Images

When Caterpillar Inc.’s chief executive officer raised the possibility on Tuesday that now could be as good as it gets, he awoke his investors and the broader market to a concern that has been nagging some of the smartest money managers for years.

The issue is that the average net profit margin of the companies in the S&P 500 Index is expected to hit just above 11 percent in the first quarter. That would be the highest since at least 1990, which is as far back as Bloomberg has compiled the data. If profit margins are not only high but at their ceiling, which is what Caterpillar’s CEO seemed to be suggesting, that would be a serious problem for the market and perhaps why — along with the fact that 10-year Treasury yields are pushing 3 percent for the first time in years —investors reacted so harshly. Stocks plunged on Tuesday and continued to drop on Wednesday in what has already been a rocky year for the market. As of midday Wednesday, the S&P 500 was down 2 percent in 2018.

New Peak

Corporate profit margins, in part because of the tax cut, are expected to hit a record

Source: Bloomberg

2018 is based on expected margins for the first quarter.

The U.S. economy, despite inflated promises from President Donald Trump, is still projected to grow at just 2.5 percent this year. The global economy is growing faster, more like 4 percent. But the market is priced for much, much higher profit growth, more like 17 percent based on where stocks are trading compared with earnings. The only way companies can get that higher profit growth is to increase their profit margins, and if companies instead experience rising costs from higher wages and higher interest expenses, then investors are sure to end up disappointed. 

What’s propelled profit margins to what could be a peak is the recently passed tax cut. But even before that, margins had been hovering at levels much higher than normal for a while. Still, concerns about how long this will persist have not been widespread. One prominent money-management firm, Grantham Mayo Van Otterloo & Co., managed by the typically skeptical investor Jeremy Grantham, seems to have been ground zero for margin concerns and more recent debate. As early as 2012, GMO strategist James Mortier called profit margins “freakish” and unsustainable. He predicted they would soon revert to a more normal 6 percent.

More recently, GMO co-founder Grantham contradicted his colleague’s view. Grantham contends a mix of globalism, consolidation and deregulation will allow margins to not only stay elevated but most likely rise. And that was before the tax cuts, which have boosted profits but also heightened and broadened the margin debate. Persistently higher profits mean that the spoils of the tax cuts will have flowed  to companies and their investors and not workers and consumers as Trump, his administration and Republicans have promised. Given the politics around the tax law, and a tighter labor market, companies may now feel more pressure to spread the wealth.

No Longer Priced for Perfection

The market's falling valuation suggests investors are worried high corporate profits are unsustainable

Source: Bloomberg

P/E based on expected profits for the next 12 months.

Profits are expected to increase 18 percent in the first quarter, but about 6 percentage points of that increase is coming from lower taxes. Exclude that gain, and profit margins in the quarter would be nearly a percentage point lower at 10.4 percent, which would still be higher than normal, but the pressure on those margins, both political and otherwise, wouldn’t be as high.

And that’s really the big problem. Stock prices are a factor not just of profits but what investors are willing to pay for them. And if the concern that profits aren’t sustainable rises faster than the profits themselves, stock prices will fall. The price-to-earnings multiple of the S&P 500, based on expected earnings, has fallen to 16.8 from a high of 20. That P/E peak in mid-December coincided, likely not coincidentally, with the passage of the tax cut.

The tax cut has worked in that it has boosted profits. But it has also pushed the market’s long-running excess to the extreme and made it just about impossible for investors and others to ignore how unsustainable big profits have become. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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