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Profit margins continue to defy the skeptics 🤑

Plus a charted review of the macro crosscurrents 🔀

Sep 10, 2023

Stocks pulled back last week with the S&P 500 shedding 1.3% to close at 4,457.49. The index is now up 16.1% year to date, up 24.6% from its October 12 closing low of 3,577.03, and down 7.1% from its January 3, 2022 record closing high of 4,796.56.

Recent market gains can be attributed to the outlook for earnings growth. And some of that expected earnings growth can be attributed to what’s arguably the most unexpected development in the corporate world over the past two years: The resilience of profit margins.

As inflation rates surged in 2021, analysts were convinced rising costs would crush profit margins.

But the opposite happened as profit margins actually rose to record levels. During this period, many companies were able to pass higher costs to their customers through higher prices. Combined with improved operating efficiencies, this dynamic led to record profits. It was a reminder that it’s “dangerous to underestimate Corporate America.”

Surprising to some, high profit margins persisted. And after a modest dip in recent quarters, profit margin expansion resumed in Q2.

“For much of the year, many believed that the combination of high inflation and rising interest rates would lead to a significant deterioration of earnings growth due to the pressure that both were perceived to have on profit margins,“ BMO Capital’s Brian Belski wrote on Tuesday. “[W]hile EBIT and net margins are certainly lower, they remain well above-average.“

Profit margins continue to trend near record high levels. (Source: BMO Capital)

In addition to benefiting from strong pricing, corporations haven’t seen interest costs spike despite higher interest rates. This is because many companies refinanced their debt in recent years, locking in low interest rates for years to come.

For more on this, read: Why higher interest rates haven't crushed corporate profits 🤔

By the way, this isn’t just an S&P 500 phenomenon. As Bloomberg’s Matthew Boesler recently reported: “After-tax profits for nonfinancial firms rose 4.5% in the second quarter, a Bureau of Economic Analysis report on gross domestic product showed. Measured as a share of gross value added — a proxy for aggregate profit margins — they rose to 14.3% from 13.8%.“

Aggregate profit margins across the economy are elevated. (Source: Bloomberg)

So, what’s next for margins?

As is often the case, there isn’t a clear consensus on the outlook for margins.

“Margins have proved surprisingly resilient this year, benefiting from the decision by many corporates to prioritize price increases over volume growth,” BNP’s Viktor Hjort wrote in a note circulated on Thursday. “This ability can be frustrated as inflation begins to trend lower, unless it can be compensated for by faster real growth.“

This prioritization of “price increases over volume growth” has become a key controversial issue in the inflation discourse as it implies consumers could be getting their goods and services for cheaper. In some cases, analysts have used terms like “excuseflation” and “greedflation” to characterize how corporations maintained high pricing for the sake of keeping margins high.

As such, there’s a thinking out there that if high inflation helped expand profit margins, then low inflation should eventually lead to contracting margins.

But not everyone is convinced margins are sure to contract — even with inflation cooling. In fact, the Wall Street consensus is for margins to continue to expand in the coming quarters.

Among other things, analysts expect companies to benefit from productivity gains yielded from operational changes made in recent years.

“From here, efficiency gains — which have been non-existent for the last 10 years — via new tools like AI and robotics could create an even more labor light benchmark, a key positive for S&P 500 margins,“ BofA’s Savita Subramanian argued on Thursday.

She shared this eye-catching showing how revenue per worker has been improving.

Companies have become increasingly labor light. (Source: BofA)

To be clear, it’ll be some time before we can clearly confirm any tangible benefits from the deployment of AI. For now, we can at least say companies are acting aggressively to integrate AI technology as reflected by the booming businesses of AI providers like Nvidia.

We’ll have to wait to see whether or not corporations are able to maintain or improve their already high margins.

That said, it’s hard to rule out the possibility that businesses will succeed on this front, especially considering the degree to which they’ve surprised to the upside in recent years.

Referenced newsletters:

Reviewing the macro crosscurrents 🔀

There were a few notable data points and macroeconomic developments from last week to consider:

💵 Money in the bank. According to Federal Reserve data, households held $4.07 trillion in cash as checkable deposits and currency in Q2, well above prepandemic levels.

For much of the economic recovery, economists have highlighted excess savings as an economic tailwind. However, it’s become difficult to define and measure excess savings. The good news is deposit data confirm that household continue to sit on a lot of cash.

For more on consumer finances, read: As some consumer tailwinds fade, new ones emerge 💨 and Don't confuse 'normalizing' with something more alarming 🤨

💼 Unemployment claims tick down. Initial claims for unemployment benefits fell to 216,000 during the week ending September 2, down from 228,000 the week prior. While this is up from the September low of 182,000, it continues to trend at levels associated with economic growth.

For more on the labor market, read: The hot but cooling labor market in 16 charts 📊🔥🧊

💼 Is the labor market heating up again? August data from LinkUp suggest the demand for labor may be picking up again. From LinkUp: “With Labor Day and the anticipation surrounding the new school year behind us, we've analyzed LinkUp's U.S. job data for August. Overall, active job listings increased by 3.0% and newly created job listings increased by 13.6%. Looking at the majority of industries and occupations, both experienced growth.“

For more on job openings, read: Were there really twice as many job openings as unemployed people? 🤨

💵 Job switchers lose pay advantage. According to the Atlanta Fed’s wage growth tracker, the gap wage growth between those who switch jobs and those who stay at their jobs continues to close. Job switchers saw 6.8% wage growth in the 12 months ending in August, whereas job stayers saw 5.5% growth during the period.

For more on why the Fed is concerned about high wage growth, read: The complicated mess of the markets and economy, explained 🧩

🎓 Student loan borrowers are paying. From BofA (via Carl Quintanilla): “…the premature spike in [student loan] repayments in August suggests that borrowers were largely prepared… and have probably made the required adjustments… good news… means that there is less downside risk to spending…“

For more, read: What the restart of student loan payments could mean for the economy 🎓

💳 Spending is up, according to card data. From Bank of America: “Total card spending per HH was up 0.7% y/y in the week ending Sep 2, according to BAC aggregated credit and debit card data. The latest data have been boosted by a shift in the timing of Labor Day weekend.“

From JPMorgan Chase: “As of 03 Sep 2023, our Chase Consumer Card spending data (unadjusted) was 1.7% above the same day last year. Based on the Chase Consumer Card data through 03 Sep 2023, our estimate of the US Census August control measure of retail sales m/m is -0.38%“

For more on spending, read: Don't underestimate the American consumer 🛍️

⛓️ Supply chain pressures ease further. The New York Fed’s Global Supply Chain Pressure Index

— a composite of various supply chain indicators — ticked up in August, but remains below levels seen even before the pandemic. It's way down from its December 2021 supply chain crisis high.

For more on the supply chain, read: We can stop calling it a supply chain crisis ⛓

🤷🏻‍♂️ Services surveys send mixed signals. The ISM’s August Services PMI signaled accelerating growth in the sector. Business activity, new orders, and employment were among the key categories showing acceleration.

However, S&P Global’s August Services PMI signaled contraction. From the report: “Business activity increased only fractionally and at the slowest pace in the current seven-month sequence of expansion. A weaker rise in output was primarily driven by a renewed contraction in new business, as client demand was reported to have been dampened by interest rate hikes and elevated inflation. The downturn was driven by subdued domestic demand, as new export orders continued to increase. As a result of the drop in new business and growing evidence of spare capacity, firms expanded their staffing numbers at the slowest pace in almost a year.“

As a general matter, soft survey data tend to be less reliable that hard data.

For more on this, read: What businesses do > what businesses say 🙊

⛽️ Gas prices are up from a year ago. From AAA: “Today’s national average of $3.80 is two cents less than a month ago but four cents less than a year ago.“

Gasoline prices haven’t been this high post-Labor Day since 2012. From Bloomberg: “Gasoline prices are now at the highest seasonal level in more than a decade even as the Labor Day holiday marked the end of the US summer driving season, sparking fears that inflation could accelerate again in a challenge to President Joe Biden’s reelection efforts… Relief at the pump is complicated by a resurgence in the cost of oil, with Brent futures topping $90 a barrel on Tuesday after Saudi Arabia and Russia extended production cuts that have already tightened global supply. Both the global benchmark and West Texas Intermediate futures are at the highest level since November.“

For more on energy prices, read: The other side of the surging oil price story 🛢

💰 Mortgage applications fall. From Mortgage Bankers Association’s Joel Kan: “Mortgage applications declined to the lowest level since December 1996, despite a drop in mortgage rates. Both purchase and refinance applications fell, with the purchase index hitting a 28-year low, as prospective buyers remain on the sidelines due to low housing inventory and elevated mortgage rates… “

🏢 Offices are very empty. From Kastle Systems: “Office occupancy remained nearly the same this past week, rising just one tenth of a point to 47.3%, according to Kastle’s 10-city Back to Work Barometer. This has been a consistent trend throughout the month. The most popular day continues to be Tuesday, which hit 55.7% this past week. Friday was the weekly low at 31.5%. Six of the 10 tracked cities experienced increases the past week, including Dallas and Houston, Texas, which both rose two tenths of a point to 54.2% and 61% occupancy, respectively. Los Angeles and San Jose, Calif. both moved 2.7 points, with Los Angeles rising to 49% and San Jose dipping to 36.1% occupancy.“

For more on office occupancy, read: This stat about offices reminds us things are far from normal 🏢

🇨🇳 China accounts for a shrinking share of U.S. imports. From Bloomberg: “China’s share of US goods imports fell to the lowest level since 2006 in the 12 months through July, according to a new report by the US Census Bureau. The share of imported merchandise coming from China was 14.6% on average over that period, the data published Wednesday showed. That’s down from a peak of 21.8% in the 12 months through March 2018, just before former US President Donald Trump ramped up a trade war with the Asian country.“

For more on the U.S. exposure to China, read: Why China's slowdown hasn't slammed the stock market 🇨🇳

📈 Near-term GDP growth estimates remain positive. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 5.6% rate in Q3.

For more on the forces bolstering economic growth, read: 9 reasons to be optimistic about the economy and markets 💪

Putting it all together 🤔

We continue to get evidence that we could see a bullish “Goldilocks” soft landing scenario where inflation cools to manageable levels without the economy having to sink into recession.

The Federal Reserve has taken on a less hawkish tone, acknowledging on February 1 that “for the first time that the disinflationary process has started.“ At its June 14 policy meeting, the Fed kept rates unchanged, ending a streak of 10 consecutive rate hikes. While the central bank lifted rates again on July 26, most economists agree that the final rate hike of the cycle is near.

In any case, inflation still has to come down more before the Fed is comfortable with price levels. So we should expect the central bank to keep monetary policy tight, which means we should be prepared for tight financial conditions (e.g. higher interest rates, tighter lending standards, and lower stock valuations) to linger.

All of this means monetary policy will be unfriendly to markets for the time being, and the risk the economy slips into a recession will be relatively elevated.

At the same time, we also know that stocks are discounting mechanisms, meaning that prices will have bottomed before the Fed signals a major dovish turn in monetary policy.

Also, it’s important to remember that while recession risks may be elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs. Those with jobs are getting raises. And many still have excess savings to tap into. Indeed, strong spending data confirms this financial resilience. So it’s too early to sound the alarm from a consumption perspective.

At this point, any downturn is unlikely to turn into economic calamity given that the financial health of consumers and businesses remains very strong.

And as always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have had a pretty rough couple of years, the long-run outlook for stocks remains positive.

For more on how the macro story is evolving, check out the the previous TKer macro crosscurrents »

TKer’s best insights about the stock market 📈

Here’s a roundup of some of TKer’s most talked-about paid and free newsletters about the stock market. All of the headlines are hyperlinked to the archived pieces.

10 truths about the stock market 📈

The stock market can be an intimidating place: It’s real money on the line, there’s an overwhelming amount of information, and people have lost fortunes in it very quickly. But it’s also a place where thoughtful investors have long accumulated a lot of wealth. The primary difference between those two outlooks is related to misconceptions about the stock market that can lead people to make poor investment decisions.

The makeup of the S&P 500 is constantly changing 🔀

Passive investing is a concept usually associated with buying and holding a fund that tracks an index. And no passive investment strategy has attracted as much attention as buying an S&P 500 index fund. However, the S&P 500 — an index of 500 of the largest U.S. companies — is anything but a static set of 500 stocks.

(Source: S&P Dow Jones indices via TKer)

The key driver of stock prices: Earnings💰

For investors, anything you can ever learn about a company matters only if it also tells you something about earnings. That’s because long-term moves in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings. Over time, the relationship between stock prices and earnings have a very tight statistical relationship.

Stomach-churning stock market sell-offs are normal🎢

Investors should always be mentally prepared for some big sell-offs in the stock market. It’s part of the deal when you invest in an asset class that is sensitive to the constant flow of good and bad news. Since 1950, the S&P 500 has seen an average annual max drawdown (i.e., the biggest intra-year sell-off) of 14%.

How stocks performed when the yield curve inverted ⚠️

There’ve been lots of talk about the “yield curve inversion,” with media outlets playing up that this bond market phenomenon may be signaling a recession. Admittedly, yield curve inversions have a pretty good track record of being followed by recessions, and recessions usually come with significant market sell-offs. But experts also caution against concluding that inverted yield curves are bulletproof leading indicators.

How the stock market performed around recessions 📉📈

Every recession in history was different. And the range of stock performance around them varied greatly. There are two things worth noting. First, recessions have always been accompanied by a significant drawdown in stock prices. Second, the stock market bottomed and inflected upward long before recessions ended.

In the stock market, time pays ⏳

Since 1928, the S&P 500 generated a positive total return more than 89% of the time over all five-year periods. Those are pretty good odds. When you extend the timeframe to 20 years, you’ll see that there’s never been a period where the S&P 500 didn’t generate a positive return.

(Source: Bespoke Investment Group via TKer)

When the Fed-sponsored market beatings could end 📈

At some point in the future, we’ll learn a new bull market in stocks has begun. Before we can get there, the Federal Reserve will likely have to take its foot off the neck of financial markets. If history is a guide, then the market should bottom weeks or months before we get that signal from the Fed.

What a strong dollar means for stocks 👑

While a strong dollar may be great news for Americans vacationing abroad and U.S. businesses importing goods from overseas, it’s a headwind for multinational U.S.-based corporations doing business in non-U.S. markets.

Economy ≠ Stock Market 🤷‍♂️

The stock market sorta reflects the economy. But also, not really. The S&P 500 is more about the manufacture and sale of goods. U.S. GDP is more about providing services.

Stanley Druckenmiller's No. 1 piece of advice for novice investors 🧐

…you don't want to buy them when earnings are great, because what are they doing when their earnings are great? They go out and expand capacity. Three or four years later, there's overcapacity and they're losing money. What about when they're losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it's going to be in 18 to 24 months as opposed to now. If you buy it now, you're buying into every single fad every single moment. Whereas if you envision the future, you're trying to imagine how that might be reflected differently in security prices.

Peter Lynch made a remarkably prescient market observation in 1994 🎯

Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs. … Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points — I don’t know which way they’ll go… They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That's all there is to it.

Warren Buffett's 'fourth law of motion' 📉

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.

The sobering stats behind 'past performance is no guarantee of future results' 📊

S&P Dow Jones Indices found that funds beat their benchmark in a given year are rarely able to continue outperforming in subsequent years. For example, 318 large-cap equity funds were in the top half of performance in 2020. Of those funds, 39% came in the top half again in 2021, and just 5% were able to extend that streak through 2022. If you set the bar even higher and consider those in the top quartile of performance, just 7% of 156 large-cap funds remained in the top quartile in 2021. No large-cap funds were able to stay in the top quartile for the three consecutive years ending in 2022.

The odds are stacked against stock pickers 🎲

Picking stocks in an attempt to beat market averages is an incredibly challenging and sometimes money-losing effort. In fact, most professional stock pickers aren’t able to do this on a consistent basis. One of the reasons for this is that most stocks don’t deliver above-average returns. According to S&P Dow Jones Indices, only 24% of the stocks in the S&P 500 outperformed the average stock’s return from 2000 to 2022. Over this period, the average return on an S&P 500 stock was 390%, while the median stock rose by just 93%.

Here’s some info on how the index is constructed, according to the NY Fed: “We use the following subcomponents of the country-specific manufacturing PMIs: ‘delivery time,’ which captures the extent to which supply chain delays in the economy impact producers—a variable that may be viewed as identifying a purely supply-side constraint; ‘backlogs,’ which quantifies the volume of orders that firms have received but have yet to either start working on or complete; and, finally, ‘purchased stocks,’ which measures the extent of inventory accumulation by firms in the economy. Note that in case of the U.S., the PMI data start only in 2007, so for the U.S. we combine the PMI data with those from the manufacturing survey of the Institute for Supply Management (ISM).“