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Summary

  • Some investors are concerned that record levels of corporate profit margins, a key contributor to earnings growth, aren’t sustainable.
  • This would put downward pressure on equity prices.
  • I believe key indicators are signaling more upside for margins and earnings this year.

By Rick Golod

About the Mid-Year Review series: I've been examining some of investors' main concerns about the current economic and market conditions, many of which are detailed in my July commentary, "Mid-Year Review: Six Investor Concerns That Aren't Worth Losing Sleep Over." I will be addressing additional investor concerns on my blog.

I've heard from many of you that you're concerned about U.S. corporate profit margins, which have been at all-time highs lately. The stock market looks vulnerable to correction if corporate profit margins can't be sustained at these levels, putting earnings growth at risk.

I still see further upside for corporate profits and earnings growth this year, in light of these positive influences:

  • Rising capacity utilization. Profit margins tend to be influenced by capital utilization. Although utilization rates are up to 79.1% from 77.3% two years ago, they remain well below 2007's peak of 80.8% and 1994's peak of 85.0%.1
  • Stronger economic growth. Corporate revenue growth is sensitive to nominal gross domestic product (GDP), which is expected to grow at trend or better.
  • Earnings upgrades outnumber downgrades. In June, the three-month S&P 500 earnings revision ratio ticked up for the third consecutive month to 1.15 from 1.07, the highest level in two years.2 (Readings above 1.0 mean more earnings upgrades than downgrades.)

Granted, at some point, margins will revert to the long-term mean. But I believe it is still too early to make that call and/or risk missing important equity gains in the meantime.

Sources

  1. RBC Capital Markets, June 30, 2014
  2. Bank of America/Merrill Lynch, July 3, 2014

Important information

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Earnings revision ratio is a ratio of analysts' earnings upgrades to earnings downgrades used to gauge analysts' sentiment about the stock market.

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Source: Mid-Year Review: Profit Margins Still Have Room To Grow