Get Ready for an Earnings Bust?

Think about this: Since 2008, gross domestic product has increased 6.4%, but corporate profits have jumped 27%.

How can profits grow so much faster than the economy? Because profit margins have been surging. In fact, corporate profits as a share of GDP are nearing an all-time high:

Source: Federal Reserve.

This scares some. As fellow Fool Alex Dumortier explained last year, profit margins tend to be mean-reverting over time. With margins at what look like cyclical highs, companies could be in for a big margin bust over the coming years. Corporate profits are now "freakishly high," according to famed investor and financial historian Jeremy Grantham. His colleague, Ben Inker, added, "The implication for the stock market is ugly, because it means earnings are unsustainably high."

This may indeed be cause for worry. The economy itself seems destined for slow growth. If margins fall, profits will grow slower than the overall economy. With stock valuations not exactly cheap, that could very well send markets like the Dow Jones Industrial Average (INDEX: ^DJI  ) lower.

But before you run out and panic, there could be another side to this story.

First, falling margins do not automatically mean falling stocks. Margins fell by over 50% from the late 1970s through the mid-1980s, and stock prices more than doubled. Margins declined by a quarter during the late 1990s, and stocks surged. Conversely, margins increased substantially during the 1970s, and stocks plunged. The past decade saw one of the largest increases in profit margins ever, and it was also one of the worst decades for stocks in modern history. If there is a connection between margins and stock returns, it might be the opposite of what seems intuitive.

But the most relevant question in this debate is why margins are at an all-time high. Here, I think there are three points to keep in mind:

  • Wages as a share of GDP are at an all-time low. Since wages are most businesses' biggest expense, low wages (due to high unemployment) help keep profit margins high.
  • Corporate taxes as a share of GDP are the lowest they've been since the 1930s. That, too, helps keep profit margins high.
  • Business investment in technology equipment is at an all-time high. This helps make businesses more efficient (doing the same work with fewer employees), which pushes margins higher.

All three have different implications on the future of profit margins.

Higher wages (primarily from lower unemployment) could cause profit margins to decline, but with it comes an obvious counterweight: More hiring means more consumer spending, more revenue, and faster growth. I don't think anyone, even Grantham, would argue that the economy is going to plunge once businesses resume hiring.

Investing in technology equipment not only promotes higher profit margins, but the gains may be long-lasting. As I've shown before, recent history has been the story of less economic growth going to workers and more going to corporate profits. That trend isn't cyclical; it's been steady for nearly 40 years. Two recent books, Race Against the Machine and The Great Stagnation, argue convincingly that this trend isn't going away anytime soon.

Taxes could be a different story. Corporate taxes as a share of GDP are low right now largely because many businesses lost a tremendous amount of money in 2008, and now have large tax-loss carryforwards to offset current tax liabilities (one reason why, for example, General Electric (NYSE: GE  ) allegedly paid no taxes in 2009). That won't last forever, and assuming current tax rates stay the same, taxes paid should increase in the coming years, causing both margins and after-tax profits to fall.

Another important point to consider is how the composition of American business has changed in the last several decades. One of the biggest shifts has been the rise of the financial industry. In 1947, finance made up 2.4% of the economy. By 1970 it was 4.2%. By 1990, 5.8%. In 2010, it was a whopping 8.4% of economic output -- an all-time high.

That can distort overall profit margins for a couple reasons. Financial profits tend to be wildly volatile, as the performances of Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) have proved. Financial margins can also be far higher than other traditional industries, particularly in the financial services and trading sectors. Goldman Sachs (NYSE: GS  ) , for example, had profit margins of over 27% in 2009, far above the broader average.

So what happens when you remove financial companies from the equation? Nonfinancial corporate profits as a share of GDP are still high, but not "freakishly" so. In fact, nonfinancial profit as a share of GDP is a mere one percentage point above the long-term average, and still below levels seen in the 1960s and 1970s:

Source: Federal Reserve.

What's it all mean? In short, not much. The argument that profit margins are bound to fall isn't as strong as it might seem, and even if they do fall, evidence that it will bring down the stock market with it is selective at best. As always, the key is buying quality companies with strong moats at good prices and hold them for a long time, with a commitment to being impervious to volatility. Everything else, as they say, is noise.

Fool contributor Morgan Housel owns Bank of America preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Bank of America. Motley Fool newsletter services have recommended buying shares of Goldman Sachs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (35)

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  • Report this Comment On November 30, 2011, at 2:53 PM, MajorBob04 wrote:

    Great article. Morgan, you support and indirectly point out what I've assumed for awhile: financial services companies are not only growing "too big to fail", they are highjacking an inordinate amount of corporate profits.

    And that's after taxpayers bailed them out (even more than we suspected - not only through TARP but the Fed helped with secret loans at very low interest rates).

    So now that they're making more profit, they've started paying their employees 2x the average.

    Overall, great article. Though I think the earnings bust will occur - except it will be worse for financial services companies. Especially with the risk in Europe and the tepid economic growth here and around the world.

  • Report this Comment On November 30, 2011, at 6:06 PM, DividendsBoom wrote:

    You are confusing accrual and cash accounting. Paying low taxes because of carry forwards from years previous would not change margins, which are calculated on an accrual basis. Taxes are still being expensed.

    Also, wages arent growing, but other expenses per employee are, like healthcare. Overall cost-of-labor (a more meaningful number) is continuing to grow, which is leading to more investment in technology as you correctly point out.

    In the end you correctly point out that it is all indeed, noise.

    I do wonder though if these corporate profits are all domestic, or just the profits of companies domiciled in the united states. Just curious Morgan, overall well done as always.

  • Report this Comment On November 30, 2011, at 6:12 PM, TMFHousel wrote:

    ^ Fair points I hadn't considered for this piece. Thanks for the feedback!

    -Morgan

  • Report this Comment On November 30, 2011, at 7:10 PM, xetn wrote:

    I am not sure the economy is growing in real terms; net of inflation. Sure, corporations are reporting increases in sales and profits, but much of that is due to price inflation. Since forth quarter 2008, the Fed has created several $trillion out of thin air and distributed that money world-wide. Several trillion new dollars without a corresponding increase in over all production. Much of the consumption has been from the federal government which is just sucking wealth out of the private sector. Government consumption is based on taxes and debt.

  • Report this Comment On November 30, 2011, at 8:56 PM, Mega wrote:

    See pages 115-116 of Siegel's Stocks for the Long Run for a counterpoint to this argument.

    1. The earnings of public companies relative to private companies have risen a lot over the past century.

    2. The percentage of US corporate revenues from foreign sources is at 44% and rising.

    There are reasons that earnings relative to GDP have been increasing since the 80s and should not just hold steady or revert to a historical mean.

  • Report this Comment On November 30, 2011, at 10:15 PM, greyone99 wrote:

    I believe that another reason is that US companies keep expanding globally (mainly in China) but these foreign profits are not included in the GDP growth which only captured US domestic production.

  • Report this Comment On December 01, 2011, at 5:29 AM, daveandrae wrote:

    You left out the fact that interest rates in the united states are at an all time LOW. As I type, a ten year US treasury bond yields 2.08% vs. a 9.14% forward earnings yield on the s&p 500. The widest spread since the 1940's.

    Lower interest expense - higher profit margins.

  • Report this Comment On December 01, 2011, at 10:27 AM, DJDynamicNC wrote:

    @xetn: I'm sure you won't be surprised that I disagree. You said:

    "I am not sure the economy is growing in real terms; net of inflation. Sure, corporations are reporting increases in sales and profits, but much of that is due to price inflation."

    Now, from the article: "Since 2008, gross domestic product has increased 6.4%, but corporate profits have jumped 27%."

    Are you suggesting that inflation since 2008 is at or near 27 percent?

    You also said: "Much of the consumption has been from the federal government which is just sucking wealth out of the private sector. Government consumption is based on taxes and debt. "

    Since government spends in the private sector, those dollars get cycled right through the economy again. If a dollar moves from me to a store to an employee to another store, that's all part of GDP and would be counted by you as wealth. But if a dollar moves from me to government to a contractor to a store to an employee, suddenly you don't count that dollar anymore, even though it's economic activity all the same. Quite frankly, that doesn't make sense to me.

    I think the disconnect is that you think dollars are real things, but that certain kinds of dollars aren't "real" based on the manner in which they were "generated." The truth is that no dollar is a real thing; we've made the entire system up, and dollars are just abstract representations that mean basically whatever the people in our society decide they mean at any given time.

    You're just applying different and much more difficult rules to the game than I am, and I'm not sure why.

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