The Good News In Tumbling Profits

by: Market Blog

By David Berman

FT Alphaville points to an interesting take from Nomura analysts on why falling U.S. corporate profit margins may not be bad at all for either the economy or the stock market.

Many observers have become suspicious that profits are in a world of their own right now, as a result of cost-cutting and the gift of ultra-low interest rates from the U.S. Federal Reserve. Indeed, corporate profit margins as a percentage of U.S. gross domestic product hit a record high of about 10 per cent in the second quarter, as against a long-term average closer to 6 per cent. Something has to give, and the skeptical view is that profits must come down, and the stock market might come down with them.

However, Nomura takes a different view. The analysts believe that if earnings stay strong in the third-quarter reporting season (set to get underway in October), then the disconnect between high profits and low economic growth should be resolved by "an improvement in economic figures -- as per the mid-2000s cycles -- rather than a collapse in [earnings per share]." By their reasoning, profit margins could come down for positive reasons, such as increased hiring, wage growth and ramped-up business spending. That's good for the economy and good for the stock market.

For evidence, they point to a number of other examples when profits peaked next to GDP. For example, in 2006, profits peaked at 8.6 per cent of GDP: Stocks rose 9.7 per cent over the next year and the U.S. economy expanded modestly. And, more dramatically, in 1984, profits peaked at 5.7 per cent of GDP and stocks rose 9.6 per cent over the next year and 39.3 per cent over the next two years.

There are exceptions, of course. After profits peaked in 1972, stocks slumped nearly 42 per cent over the next two years and the U.S. economy pretty much stalled.