Rising star of the US financial newsletter world, Chris Mayer, has a stark warning for readers in his latest issue of Capital & Crisis (click here). Profit margins in the US have reached unprecedented levels and can now only fall as commodity price inflation hits home. One of the vulnerabilities in today’s market is that profit margins are near peaks’, he says. ‘Investors tend to like companies with fat profit margins, but high profit margins are like honey pots that attract competitors. They are rarely sustainable for long.
One of the vulnerabilities in today’s market is that profit margins are near peaks’, he says. ‘Investors tend to like companies with fat profit margins, but high profit margins are like honey pots that attract competitors. They are rarely sustainable for long.
Top ten crisis
If you take a list of the top 10 technology stocks in the US Nasdaq market, the average net profit margin is around 25 per cent, and similar high profit margins are also seen across the S&P 500 stocks. The boost to profit margins has come from cost cutting in the downturn, mainly in the form of job cuts that do nothing to boost domestic consumer demand.
Today, though, I doubt many of these firms have much more to cut,’ suggests Mayer. ‘Instead, the focus is now growing sales and taking business from competitors or defending an existing business. The focus, too, is how to deal with rising raw material costs. All of these put enormous pressure on margins. We should expect to see them fall.
That of course is the contrarian view. It is not what the bulls of Wall Street are saying. They see a recovery in the US economy that is raising all boats.
If the Wall Street consensus is again wrong, then the reverse will be true and all boats will sink. Mr Meyer is stock picking to locate the boats that will stay afloat, so at least he is thinking in the right direction. But the tendency always is for the good to get cast down with the bad, particularly if the numbers are overwhelming.
Naturally, this situation is most dangerous when company profits have recovered sharply and the domestic economy is still in the dumps. And what do US auto and house sales figures quite clearly show us? (click here). The domestic US economy is still in a depression with activity well down on the boom years.
Now if domestic demand is not rising, and indeed consumer personal disposable income is falling (click here), then what prospects are there for pushing up company revenues to keep profits surging ahead? You have to look to exports and repatriation of multinational income.
Yes but does the world not have a few worries of its own right now? To briefly summize: Japan just had its worst earthquake in history and nuclear reactors are leaking plutonium; the UK is facing three years of austerity; the eurozone has a massive debt crisis and the Middle East and North Africa are in a state of revolution, civil war and protest that have pushed oil prices to a two-year high.
Will Asian sales hold up under these circumstances? Or will stocks sell off and the dollar rally, making US exports uncompetitive again? This peak profits warning is very well timed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.