The Case For Equities: The Future Of Corporate Profit Margins

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With the economic recovery stalling and continuing crises in Europe, U.S. equity investors are understandably nervous about the prospect for stocks. Halfway through 2012, the S&P 500 index is up 7.5%, but volatility remains high, with the market moving up or down by more than 1% twenty-eight times so far this year as the market seems to be driven more by news out of Europe than by companies' fundamental earnings prospects.

All this noise may obscure a surprising fact: U.S. corporate profits, as a percentage of the economy, are at an all-time high. The market, though, may not be giving companies much credit for those robust margins: despite positive returns on stocks this year, and continuing fund flows into equities, the S&P 500 trades at just under 14x trailing-12-month earnings, well below the 10-year average of almost 17x. This suggests an expectation that current robust profit margins cannot continue; indeed, analysts at Goldman Sachs calculated an implied EPS growth rate for the S&P of negative 12.6% over the next five years.

A more optimistic view would take a retreat from current record profit margins as good news for equities. Part of the explanation for high profit margins is that companies are starting to see revenues return even while they are positioned for recession. They have pared back their expenses since the start of the financial crisis, spending less on product development and, in particular, on wages: while mass layoffs have tapered off, hiring remains sluggish, and companies remain unwilling to commit to hiring many new full-time workers.

As long as hiring and wage growth remain sluggish, so will the broader economic recovery, and demand for U.S. companies' goods and services. In such an environment profit margins may stay high, but revenue growth will be hard to come by. And while profit margins are nice, they are no substitute for top-line growth. When companies face pressure on wages from workers with more options and more bargaining power, it may reduce their margins - but that may be good news for the economy, and for equity investors.

This article was made possible by support from OppenheimerFunds.

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