America's New Boom and What Could Drive Profits Higher

Investors like stories. It's how they take impossibly complex things like economies and distill them down to whatever they want to believe.

Among market bears -- and there are a lot of them now that the S&P 500 has dropped 5% (typical) -- the most popular story goes like this: Profit margins are at all-time highs. Historically, profit margins revert to the mean. When they do, profits will fall. And that will hurt stocks. Worse, companies have already shed so many workers and cut so many costs that there's really no way profit margins can go much higher than they already are.

Here's a quote from a Bloomberg article this morning:

"Now that profitability has been basically pushed up toward peak levels, in order to get earnings to go higher from here, who else are you going to fire? What else are you going to cut?," Kevin Caron, a Florham Park, New Jersey-based market strategist at Stifel Nicolaus & Co., which oversees about $150 billion, said by phone Aug. 29. "The trillion-dollar question is what drives the rally from here?"

Stop. 

In order to get earnings to go higher from here, who else are you going to fire? What else are you going to cut?

Think about that for a second. It implies that the only way companies can grow earnings is to fire workers and cut costs.

Which is nonsense. What ever happened to companies investing in their future? What happened to economic growth?

The problem with the margins-will-revert-to-the-mean story is that a lot of other things also revert to the mean, and those other things could offset any damage falling margins have on profits.

Take fixed private investment -- spending by businesses and households on fixed assets like factories and homes. As a share of GDP, it's still well below its historical average:

Source: Bureau of Economic Analysis.

If you're worried about profit margins reverting to the mean, I have to ask: What's going to happen when fixed investment reverts to the mean, too? Is that going to eventually boost profits? Help the economy grow? Create jobs that boost demand and help businesses grow revenue, and hence push profits up?

Of course it will.

Or take state and local government spending. It usually contributes about a third of a percentage point to annual GDP growth. But because of austerity, it's subtracted an average of a third of point from GDP over the last three years:

Source: Bureau of Economic Analysis.

If you're worried about profit margins reverting to the mean, I have to ask: What's going to happen when state and local spending reverts to the mean, too? Is that going to boost GDP growth? Create jobs that boost demand and help businesses grow revenue, and hence push profits up?

Of course it will.

Now both of these are just "stories" as well. The economy could boom, or a new recession could sprout up, or profits might keep booming, or fall off a cliff.The point is, there are trillions of moving parts in the economy, and simple, one-line narratives like "profit margins are going to revert, and that's bad for stocks" almost always end up wrong in hindsight. Margins fell in the 1980s, and stocks doubled. They fell in the 1990s, and stocks doubled again.

There are an uncountable number of variables interacting in the economy at the same time, and when people focus on just one that fits the narrative of their choice, they are exercising confirmation bias far more than they are performing financial analysis.

Any time someone points out that some variable changing is going to affect the economy, there needs to be an asterisks that says "all else equal." The problem is, all else never is.

More from the Motley Fool 
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