Big Market Worries: Profit Margins
Comment of the Day

February 23 2012

Commentary by David Fuller

Big Market Worries: Profit Margins

My thanks to a subscriber for this informative item by Jeff Miller. Here is the conclusion:
Let's face it. The argument about mean reversion in profits is several years old. Profits keep rising and margins have held up pretty well, mostly because companies have been slow to bring back employees. The P/E multiple declines, partly because the world is full of skeptics about future profits.

The leading advocate of profit mean reversion is Vitaliy N. Katsenelson. I did a favorable review of his excellent book, which has excellent advice on stock picking. A book about a sideways market is a coup on many fronts, and I enjoyed reading it.

Unfortunately, many investors are convinced from these arguments that profits are about to decline. This conclusion is not supported by the data.

High profit margins came when companies held down costs and new hiring. If the margins fall, it implies that new workers have been added. That is the basis for additional costs. This means that employment, GDP, and tax revenue are all moving higher.

Briefly put -- Those who look at mean reversion in profits alone, without any attention to changes in employment, are guilty of an inconsistent forecast.

I have a simple challenge for those forecasting a mean reversion in profits: Do you really expect the overall S&P earnings forecast to move lower?

If not, why should we care about profit margins?

David Fuller's view Jeff Miller is right in saying that many companies are not hiring, and of course they laid-off plenty of workers following 2008. However, the Autonomies (Fullermoney's name for the big, successful multinational companies which dominate their sectors) have seen their profits rise primarily because of three other factors: 1) they are increasing their presence in the world's growth economies; 2) they are benefiting from the exponential growth in cost-saving technology; 3) interest rates in the so-called developed economies remain near record low levels.

I see only one big short to medium-term threat to corporate profits - the price of crude oil (Brent & WTI).

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