Margins Don't Have To Decrease As Much As Some Pundits Claim

Includes: SPY
by: Tom Armistead

Corporate profits as a percentage of GDP stand at near record levels. Bearish pundits point at this and assert that margins will revert to their historical average, leading to a plunge in profits and share prices. Working with data provided by the BEA (Bureau of Economic Analysis), this article explores that idea and arrives at a more moderate conclusion.

Sharing the Pie


Rather than use GDP, this analysis considers the shares of labor, capital, taxes and profits as part of value added. These shares sum to 100%. This walks around the issue of commodity cost: commodities aren't included. Logically, if commodities rise, commodity producers will show higher profits, offsetting lower profits for other businesses.

The trends are very clear, and consistent with anecdotal evidence and popular wisdom. Labor is getting a smaller share of the pie, and corporate profits are increasing accordingly. The correlation between labor and profits is -88%. This reflects the relative bargaining power of the two groups in a global economy.

Capital, defined as consumption of fixed capital plus interest, is taking a steadily increasing share. Taxes are negatively correlated with capital, at -84%. Industry is more capital intensive than in was in the late sixties. The inverse correlation between taxes and capital shows clearly in the chart: perhaps it reflects government efforts to employ tax policy to stimulate investment.

Revert to Mean, or to Trend?

Reversion to the mean is a powerful force. However, when the data is considered with the relative bargaining power and motivations of the various claimants in mind, it seems more likely that established trends will continue indefinitely. International corporations can play labor and governments in various countries against each other, moving production or the booking of profits to jurisdictions where the cost of labor and taxes is lowest.

The linear regressions are persuasive. If by 2015 margins return to the trend line, profits will decrease from 10.3% to 9.1%, hardly a catastrophic collapse. Expressed as a percentage, it's an 11.7% reduction.

S&P estimates as reported earnings for the index at $103.19 for 12/31/2013. Reducing that by 11.7% (for reduced margins), and applying a 60 year average PE of 16.4 (per Eddy Elfenbien), a value of 1,495 emerges. With the S&P 500 (NYSEARCA:SPY) at 1,411, reduced margins are already priced in, and haven't happened yet.

The missing profits will show up as increased compensation. Again assuming a return to the trend line by 2015, labor's share will increase from 60.7% to 63.1%. If that occurs, the US economy, which is driven in large part by consumer spending, will respond strongly.

I speculate that the financial crisis may have demonstrated to management that their bargaining power relative to labor is far stronger than they previously realized. Or the depth of the downturn may have created a permanent pool of workers who have little choice but to accept what's offered. Possibly the crisis was a watershed event.

Same Data Set, Different View

The customary way of presenting data on margins is reflected in the following chart from the St. Louis Fed:

A large part of the contrast with the presentation made earlier in the article lies in the scaling: this chart covers an area from 2% to 11%, while the other is scaled from 0% to 80%.

The thought process is different, in that when the other claims for a share of value added are explicitly considered, the tug of war between labor and profits is highlighted. Labor, capital and profits take up 86.5%, the remainder goes to taxes.

BEA Data vs. S&P Data

The assumption that BEA data can equated with data on the S&P 500 is incorrect: the S&P 500 is only a part of the larger whole. Also, BEA data is more akin to tax accounting than GAAP accounting. Finally, the subset of data I selected doesn't include the financials.

S&P provides quarterly information on the sales and as reported earnings of the index, which can be used to develop profit margins. The following table compares recent history for these two versions of margin:

2008 is an outlier: if it is removed, correlation improves to 80%, and the average values are closer. The real economy continued to function in 2008 and 2009. The crisis was exacerbated by mark to market accounting and derivative replication and transmission of losses.

Investment Implications

Based on this analysis, a catastrophic collapse of profit margins for US non-financial corporations is unlikely. A correction, in the form of a return to the trend line, would most likely be beneficial, in that it would increase consumer spending power, which in turn drives 70% of the economy.

While I am hedged for a short-term downturn, I continue to invest on the basis that returns on US equities will be above average over the next 5 years.

Disclosure: I own puts on SPY: however I am net long by ownership of the Vanguard S&P 500 Index Mutal Fund. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.