Sonders on Why Those High Profit Margins Aren't So High

In recent years, there’s been a lot of talk about how profit margins have reached unsustainable levels and will revert to their historic mean, which would have negative consequences for both corporate earnings and the stock market. But in a new analysis, Charles Schwab Chief Investment Strategist Liz And Sonders provides some interesting data indicating otherwise, saying that margins may continue to expand — or appear to continue to expand — even though earnings growth has peaked.

In commentary posted on Schwab’s site, Sonders notes that some common measures of profit margins — most notably the ratio of US pretax corporate profits relative to US corporate gross domestic product, which is near a 60-year high — are likely being significantly skewed because of globalization. “Today’s elevated margins are approaching the highly profitable years of the 1950s,” Sonders writes. “But it’s important to note the key difference between economic conditions of the two eras. In the 1950s, the US economy was essentially a closed system, with foreign trade and overseas investment much, much lower than today. As such, an even better measure of today’s margins should have profits assessed in relation to both domestic and foreign sales. Unfortunately, national income accounts do not track such data, and as a result, using the more-common measures of profit margins can and likely will be misleading.”

Looking at data that compares domestic profits with domestic sales shows that domestic margins are only about 14% — that’s on the high side for the past 40 years, but far below levels seen in the 50s and 60s. “When measured this way, profit margins look significantly less elevated,” Sonders says. “With globalization in full force, foreign earnings’ contributions to US profit growth should continue to expand, suggesting that margins may continue to diverge somewhat from the US business cycle, and that their upward trajectory may not be soon interrupted (barring a synchronized global recession).”

Sonders also provides data showing that stock market performance one year and two years after profit margin peaks has been quite good, and that future stock market returns tend to be best when earnings growth isn’t sky-high.