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Will Record Profit Margins Cause Stock Prices To Plunge?

Profit margins in 2013 and 2014 climbed to new record levels not seen since early 1970.  On financial cable TV, bearish forecasters started saying profit margins were unsustainable and stock prices had to drop.  Are they right?

To be sure, the stock market can fall at any time based on a sudden change in investor sentiment.  That risk is always inherent in stocks.  However, the economic reality that drives stock prices makes a sudden shift in sentiment unlikely.

Fact is, lower interest expenses and lower taxes are bolstering profit margins and those very favorable fundamentals mean the record level of profits on the Standard & Poor's 500 are unlikely to revert to its historical mean anytime soon.

According to data from the U.S. Bureau of Economic Analysis, the percentage of the U.S. economy (gross domestic product) going toward paying employees declined sharply since 1970, while the percent of GDP to buy fixed capital – all kinds of goods — steadily rose.

While the decline in compensation may sound like bad news, the net effect is that America is replacing labor with capital.  While that may sound Orwellian or scary to some, it's actually good. American productivity over the last several decades progressively increased.

Increasing national productivity can raise living standards.  More real income improves people's ability to purchase goods and services, enjoy leisure, improve housing and education and contribute to social and environmental programs.  Productivity growth also makes businesses more profitable, which is what drives stock prices.

While some pundits on TV raise fears by arguing that the margin of profits shown by blue-chip companies must revert to its long term annual mean of 5%, increased productivity makes that unlikely to happen anytime soon.  Lower interest expenses and lower corporate taxes — two key fundamentals driving earnings— are unlikely to reverse course anytime soon.

"When you hear one of the TV financial advice columnists saying corporate profit margins are unsustainable and that it raises the risk of owning stocks, remember that earnings drive stock prices," says independent economist Fritz Meyer.  "And with Congress under pressure to cut — not raise — corporate taxes, and with interest rates unlikely to rise sharply in 2014, the fundamentals underpinning stock prices are likely to change anytime soon.

Key measures of whether stocks are overbought have changed over the decades.  Price-to-book ratio made sense in the 1930s, when first applied by Benjamin Graham but it is used differently because of changes in the economy.  Other market valuation metrics, like Tobin's Q and the ratio of a company's market capitalization versus U.S. GDP, while reliable in the past, are no longer accorded the same validity.  Times change.  Similarly, just because profit margins are at record levels does not necessarily mean they must revert to their mean and cause a sudden drop in stock prices. 



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