One of the more remarkable stories since the beginning of the "Great Recession" and the subsequent bout of sub-trend growth has been the ever upward march of corporate profitability in the United States. S&P 500 earnings going into this earnings season are at or near all-time highs and should remain there this earnings season despite what will probably turn out to be another mediocre quarter in terms of quarter over quarter and year over year growth. Profit growth in the US has received one heckuva tailwind from one source: margin growth. Corporate profits as a percentage of nominal GDP are now at or near all-time highs (see chart).
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| Bureau of Economic Analysis, Bloomberg, and IronHorse Capital |
Except for the hiccup associated with the 2008/2009 economic crisis, margins have remained high for the past decade. Of course, companies in the US have been highly effective in terms of doing more with less over the past several years, increasing the productivity of existing workers, cutting costs, and improving manufacturing processes, among other things. Increasing global, ex-US, sales growth among US companies has most likely helped significantly as well. Certainly one of the biggest tailwinds has been the fact that labor costs have been subdued over the past few years due to several factors. High unemployment, hence a high supply of labor has kept wages subdued as workers compete with one another for open jobs. The continued opening up of global labor pools has also contributed to this phenomenon. Vast improvements in communication technology and the sophistication of global supply chains have allowed companies to move lower skill work to other countries. Increasingly, companies have found opportunities to move higher skill service and analyst positions overseas.
At some point, however, this well will run dry, maybe sooner rather than later. As seen below in the chart created by the Cleveland Fed, the Labor share of national income, which had remained in a relatively tight range for about 50 years, began to fall dramatically in 2000.
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| Federal Reserve Bank of Cleveland |
This provides a stark graphic representation of some of the forces described above. It's no coincidence that this represents a mirror image of the profitability graph. Some of the declines represented below are structural and long-term in nature; more than likely the long-term trend has downshifted. Even so, this has been a mean reverting series as has the profit margin series. At some point, for whatever reasons economic and/or political, this decline will be arrested and begin to upshift and corporate margins will begin to come back to earth (and will probably overshoot to the downside at some point in the future).
Profit margin peaks and troughs have been very closely associated with peaks and troughs in the S&P 500 over the past 50 years. This earnings season and beyond, these forces warrant close observation by domestic investors. When margins have broken to the downside in past episodes, usually the retreat was swift.
Profit margin peaks and troughs have been very closely associated with peaks and troughs in the S&P 500 over the past 50 years. This earnings season and beyond, these forces warrant close observation by domestic investors. When margins have broken to the downside in past episodes, usually the retreat was swift.
