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Denis Ouellet
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Denis Ouellet has been involved in the Financial sector since 1975. Now retired, he is a part-time blogger. Denis has been analyst and head of research for a brokerage company, equity manager for various investment organizations (pension, mutual and hedge funds), head of global equity... More
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Fidanza Publishing
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BEARNOBULL
  • MARGIN CALL! 0 comments
    Feb 27, 2011 8:20 AM
     Much is being written these days on the US corporate margin squeeze developing from rising commodity prices. Zero Hedge’s Tyler Durden first wrote about that in December:

    Today’s Philly Fed current activity index came at what at first glance appears to be a healthy 24.3 in December from 22.5 in November on expectations of 15.0. Great right? Nope. (…) what was most notable is the absolute explosion in the Prices Paid index which followed mortgage yields in going parabolic. From 34 in November, the Price Paid index surged to 51.2! Recall David Rosenberg discussing the mother of all margin squeezes yesterday… It’s here. From the index: “Price increases for inputs as well as firms’ own manufactured goods are more widespread this month. Fifty-two percent of the firms reported higher prices for inputs, compared with 38 percent in the previous month. The prices paid index, which increased 17 points this month, has increased 41 points over the past three months. On balance,  firms also reported a rise in prices for manufactured goods: More firms reported increases in prices (21 percent) than reported decreases (10 percent), and the prices received index increased 13 points, its first positive reading in eight months.” Add to this the earlier comments from Fedex that the main reason for the EPS miss (not so much revenue) was due to a spike in labor costs, and one wonders: Quo Vadis Deflation?

    David Rosenberg got back to the same theme yesterday:

    We saw more evidence that companies are facing an intense profit margin squeeze with the recent macro data. The chart below is the spread between Philly Fed prices paid (input costs) and received (prices charged). The last time the spread was at 46.2 was in June 1979 … that was not a good foreboding: the four-quarter EPS trend swung from +21% to -9% a year later. The producer price index data told the same story on margins — the ratio of PPI at the crude stage to PPI at the final gate just broke above 1.3x … there were only three other episodes where this ratio was above 1.3 … in each case, EPS growth slowed substantially all three times in the next year.

    But if one starts digging and uncover a potential problem, one should not stop digging and just cry wolf. Let’s keep digging this margin call.

    US corporate profit margins are high and, as such,  vulnerable, something the bears happily point out. One pundit wrote:

    When corporate profit margins are shrinking, profits grow more slowly than revenues, and stock multiples usually contract.

    He kind of stopped there, leaving the seemingly obvious conclusion up in the air without bringing any tangible support.

    I used his chart which clearly demonstrated a decline in profit margins as per the GDP accounts but I checked what happened to S&P 500 EPS and the index itself while the margins were being squeezed.

    image

    In 3 of these 4 “mothers of all margin squeezes”, S&P 500 EPS kept growing. Shrinking margins do mean profits grow more slowly than revenues but, as the chart above shows, not necessarily that multiples “usually”contract. In fact, based on the evidence from the chart, the jury is about evenly split on multiple movements when margins contract meaningfully from current high levels. History convincingly shows that PE multiples are primarily a function of interest rates, therefore of inflation rates and trends thereof (seeS&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years).

    It is also important to note that often margins did not go straight down, staying elevated for periods of 9-15 months after peaking. Furthermore, in all four instances, equities did rather well, at least in the early part of the margin contraction period.

    I then looked at the Philly Fed “Prices Paid Minus Prices Received” Index. Rather than using David Rosenberg’s chart which only goes back to 1990, I used Doug Short’s which goes back to 1968.

    I transposed on a semi-log earnings chart the 7 instances when the Philly Fed “Margins” index reached extreme levels. The “R” on the chart indicates US recession periods. S&P 500 profits have, in fact, declined after the “Margins” index rose smartly but only when there was a US recession, negating the usefulness of the indicator.

    image

    So, simply saying or implying that elevated profit margins are bearish is incomplete analysis to say the least.

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