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The S&P 500 is closing in on its highest printing in four years on improved risk sentiment based on the belief that the economy is improving. This belief is supported by the economic data, as consumer confidence continues to improve while the national unemployment rate continues to drop. In addition to this, corporate earnings reports have consistently beaten market estimates and are now seen at their highest levels ever. The main question for equity markets going forward is whether or not this earnings boom has run its course and is ready to drift backward toward the long term historical averages.

One argument for why this might be the case can be seen in profit margins (the ratio of income to total sales figures). For the last 50 years, corporate earnings have been equal to roughly 6 percent of the annual GDP in the US. Today, it is closer to 10 percent and many analysts have argued that this is suggestive of a trend scenario that is no longer unsustainable. Any retracements here (a simple reversion to the mean) would be viewed by many as a clear negative both for individual earnings reports and for the broader stock indices as a whole.

So, the main question long term investors should be asking is whether or not a decline in profit margins is a realistic possibility and what effect this would have on stock shares if this does, in fact, come to fruition. What exactly is the relationship between profit growth and margins? Here we will argue that there is probably less of a connection here than most would normally think. What is the relationship between invested stock returns and the profit margins achieved by the underlying companies? History shows the relationship is minimal, at best.

It should be noted that declines in margins inevitably will have a negative impact on profit figures, but this is only true as long as all other relevant factors remain the same. But since this is almost never the case, investors should prepare for alternative scenarios. More normally, profit margin fluctuations are seen when changes are seen in interest rates, taxes, revenues and economic growth. In general, the last 50 years have shown us that the relationship between corporate growth and profit margins have little to no correlation.

In today's markets, we have seen large increases in profit margins, mostly coming as a result of increases in foreign sales and the greater influence of technology companies (which tend to have larger margins than any of the other companies in the industrial sector). With both of these areas expected to show larger and larger increases in the coming years, what we have essentially is an argument for perpetually higher margins.

A look at the trends from the last 50 years shows that tech-based companies have grown to become nearly 5 percent of annual GDP figures. In that same period, manufacturing companies have dropped from 25% of GDP to roughly 10 percent at the beginning of 2010. Virtually no one expects this trend to reverse in the future, so there is little to suggest that margins will be seen changing trend any time soon.

Another factor to consider is the continual goal for companies to reduce waste and boost efficiency. During our 50 year time frame, employee salary levels have dropped relative to GDP and this trend started to reach extreme levels in 2008 as overhead was reduced and employee efficiency was increased so that profits could be maintained when the wider economy was in decline.

The alternative possibility would be if margins fell when businesses start hiring more workers and are forced to pay higher salaries in order to meet their staffing needs. But in this case as well, profits would be aided by the lower levels of national unemployment and a consumer base with a larger amount of disposable income. Even if margins are seen lower, profits still have the potential to come in very strongly, which is what happened late in the 1990s when margins dropped to 5 percent (on higher compensation costs) but profits still improved (on larger revenues). The most probable scenario is that this trend continues, with margins seeing declines but profits maintaining a high level of strength.

So, what does this mean for long term investors? Essentially, what needs to be remembered is that when stocks are inexpensive relative to other asset classes, substantial earnings growth is not a prerequisite for impressive returns. Conversely, when stock prices are relatively expensive, substantial earnings growth can actually cause losses for long term investors. Lower profit margins in the 1950s came along with declines in earnings growth but this was not what was seen in share prices, which rallied because of their relatively cheap price levels. A similar scenario occurred in the 1980s, and in the 2000s profit growth increased at the greatest rate in history despite being one of the worst decades in investment returns (given the overvalued prices that were seen in 2000).

Looking ahead, the main issue for investors is whether or not the current price levels in the stock market are representative of an undervalued or overvalued asset class. This is where the discussion gets difficult because there are a range of answers, depending on who you ask. Either way, however, the underlying ideas are unchanged as falling margins or falling earnings should not be the primary concern. The real issue is whether or not market valuations accurately forecast either of those scenarios, as stock performance is relative and strongly based on these expectations.

Source: Assessing Potential Margin Threats To The 2012 Stock Rally