What Goes Up, Must Come Down…Time For a Major Profits Correction?

As the first quarter earnings season draws to a close, the results have actually been quite a bit better than expected. The “beat rate,” or the percentage of companies beating the consensus estimate going into the earnings announcement, is running at 67%. The average beat rate of the past five years has been 65%.

Of course, it’s a lot easier to beat expectations when they’re low enough, and analysts weren’t expecting a whole lot this quarter. Between bad winter weather, a strong dollar and an implosion of profits in the energy sector, analysts went into the season downright cranky.

But let’s step back and look at earnings through a wider lens.

Back in April, I recounted an article that Warren Buffett wrote in 1999 that speaks to today just as well as it did then.

At the time, Buffett suggested that in order for stocks to continue rising from their already elevated levels, earnings would need to expand to an ever-larger percentage of GDP.

Well, they didn’t… and we had one of the worst bear markets in history from 2000 to 2002.

Today, let’s look at after-tax profit margins to get a little perspective on where corporate profits are sitting. As you can see in the chart below, margins have fluctuated in a band of about 4% to 8% since the late 1940s. The white-shaded areas represent periods when the economy was in recession.

may 11

This shows that profits tend to peak several years before a recession. And not only does it look like they’re falling off their peak today, they’ve climbed to highs you’d be hard pressed to consider “normal.”

During the 1990s bubble, corporate profit margins peaked in the mid-1990s, and had already been falling for years by the time the stock market bubble finally burst.

Likewise, before the 2008 meltdown, profit margins had already topped out and had started falling a couple years prior.

Now, they seem to be following the same path.

Profit margins are so high today because companies have basically axed capital spending since 2008. With domestic demand so weak, and investing in dividends and buybacks being the more profitable venture, capital spending for them just hasn’t been worth it. That’s led profit margins to rise to these — frankly — startling levels.

But that’s not all. Falling bond yields have also lowered borrowing costs, which has boosted earnings further. And high unemployment and automation has kept labor costs in check.

All of these conditions may stay in place a little longer, but they won’t last forever. We’re due for a major profits correction, and we may already be in the early stages of one.

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Charles

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About Author

Charles Sizemore is a research analyst with Dent Research. His primary research focuses on income, retirement strategies and fundamentals.