Profit Margins Won’t Meet Estimates

In this article, I will elaborate on my previous point about S&P 500 profit margins; I will also discuss the latest updates surrounding the healthcare vote on Thursday. These two topics both hit on the catalysts which will move stocks, namely earnings and fiscal policy. Stocks got a free pass in 2015 when earnings fell because the Fed was extremely dovishness. Part of the reason for this dovishness was the divided government which couldn’t get things done. Supposedly the government will now be functional because one party controls the legislative and the executive branch, but I have my doubts. I also think the Fed went too far in trying to make up for fiscal policy. The goal of fiscal policy isn’t necessarily to boost the short-term economy. Therefore, I think the Fed saying it was making up for fiscal policy was set up by a false premise.

Profit Margins

I have many problems with the consensus analyst estimates. One of them is that the expectations for profit margins are unrealistic. Technically almost all earnings estimates start out too high, but the growth usually isn’t as unlikely as the current profit margin expectations. The consensus for 2017 S&P 500 earnings expects them to grow 9.8%. Revenues are only expected to grow 5.3%, meaning margin improvements are expected. Margins are expected to rise further in 2018 as earnings are expected to increase 12% while revenues are only expected to grow 4.8%. Trailing profit margins are at 9.5%. Trailing profit margins peaked at about 10.2% in 2015. With these estimates, analysts are expecting new record high margins.

The chart below isn’t updated with the latest data, but it gives you a good picture of where corporate profit margins have been historically. The bulls claim that stock multiples should be high because bond yields are low, but the bears claim stock multiples should be low because profit margins usually revert to the mean. Stocks are historically expensive now; a profit margin reversion would lead to a crash in equities.

The chart below shows the historical forward S&P 500 profit margins. As you can see, the forward margins are higher than the peak in 2007. Profit margins have plateaued at levels which are associated with peaks. 2018 forward profit margins are expected to be higher than ever before.

Part of the reason margins are to expected increase is because the corporate tax rate is expected to be cut by the GOP from 35% to 20%. Whether that will happen depends on the legislative success of healthcare which I will go over later. There’s two problems with this logic. The first is that corporations’ current average effective tax rate is about 29%. The tax cut looks bigger than it is. Secondly, a border adjusted tax will be put in place to supplement the lost government revenue. Any firms whose profits depend on the consumer’s disposable income will be hurt.

As you can see from the chart below, corporations are already paying an historically low corporate tax as a share of GDP. The bright side is that taxes won’t be raised which is positive for the narrative that profit margins will stay at their plateau. The negative is that tax collection can’t be cut much more. Corporate income tax since 2009, when this chart ends, have ticked up moderately to 1.9% in 2015, but my point that they’re historically low still stands. According to the government, the corporate income tax as a percentage of GDP will rise to 2.6% in 2020. That estimate will have to be lowered if Trump cuts taxes.

On a cyclical basis, one reason why profit margins should fall in the next few years is because the labor market is getting tight. The chart below shows that jobless claims are inversely correlated with S&P 500 profit margins. On the other hand, because of the high number of discouraged workers, the slack in the labor market is greater than usual. This means profit margins may stay high for longer than usual.

One of the sectors which is expected to improve its margins is the financials. I have explained in my previous article why the financials may not have a bright future. Lending standards are tightening which signals the credit market is headed for a stress period.

Healthcare Vote

In previous articles, I gave the wrong number of votes in the House that the heath care plan needs to pass. Because President Trump doesn’t have a full cabinet, the healthcare plan only needs 215 votes to pass. The chart below shows the potential vote breakdown as of Wednesday. That is not likely to be exactly correct because of the last-minute push to get it to pass.

I would categorize the bill getting 210 votes as being the worst-case scenario. It’s what the vote will look like if the establishment GOP in Congress and the White House can’t move any more conservatives to vote in favor of the bill. The latest report is that the Freedom Caucus is considering supporting the bill because the establishment GOP offered to eliminate essential health benefits. If the Freedom Caucus supports the plan, it will pass. At this point, I would say the plan has a better chance of passing than not. As I said previously, usually when the leadership pushes for a vote, it does so because it knows it has enough votes. If the Freedom Caucus doesn’t endorse the plan, it may still pass since the leadership only needs to convince five more Representatives to change their minds.

I think the stock market will rally in response to this successful first step for healthcare reform. It will be tough for it to pass the Senate, but it’s not improbable. The conservatives in the Senate will negotiate just like the Freedom Caucus did.


In this article, I explained why profit margins won’t meet expectations. This is bearish for stocks. On the bright side, healthcare reform looks like it may pass the House of Representatives. We will know what will happen in about 12 hours. If it passes, stocks will rally and if it doesn’t, stocks will fall.

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