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Will Record Profit Margins Upend The Bull Market?

Ultimately, what drives stock prices is profits.  Profit margins in recent years expanded beyond historic norms, leading to speculation lately about what might happen if margins were to revert to their long-term mean.  It almost certainly would be a disaster for stocks.  When you look at the facts, however, it seems unlikely profit margins will come under pressure anytime soon.  To the contrary, economic fundamentals indicate that profit margins could continue to expand.

Profit margins have expanded by three percentage points since the 1970s, according to Fritz Meyer Economic Research.  The share of gross domestic income that goes to compensation of employees, or labor costs, declined by 6½-percentage points.  Meanwhile, the share of domestic income going to pay for fixed capital increased by 3%.  The difference—3.5 percentage points of U.S. gross domestic income—has been accrued by corporations, pumping up their profit margins.  An historic replacement of labor with capital, which has been an astounding period for productivity growth, has unfolded over the last four decades.

And that’s not the only factor causing an expansion of profit margins in corporate America.  The other reason profit margins have grown fatter—and provided a bullish backdrop for investors in stocks—is that net interest expense has declined by four percentage points, which likewise boosted corporate profit margins by four percentage points.  On top of that, a gradual decline in corporate income taxes helped to boost profit margins further.  Altogether, this confluence of economic circumstances created an economic and investment climate propelling profit margins to record levels.  Better still for investors, these fundamental factors are unlikely to reverse, much less suddenly collapse.

The drivers of profit-margin growth is that companies are realizing that lowering labor expense by buying capital is a tradeoff well worth making, and the trend is accelerating.  While these broad trends cause massive changes in people’s lives and families, they are good overall for the economy in the long haul.

The relentless substitution of capital for labor over the last few decades can continue even as the economy makes gains in employment.  In fact, unemployment, the stubborn problem hampering the economy since The Great Recession of 2008-2009, has at long last been settling toward its long-term norm of 4%.

At the same time, interest expenses are unlikely to rise sharply anytime soon.  “With inflation low and some slack still present in the job market, sharply higher interest rates are unlikely right around the corner,” says Fritz Meyer, an independent economist.  Meanwhile, pressure is mounting on Congress to lower corporate taxes in order to bring U.S. corporate income tax rates in line with those of other developed nations.  This sets the stage for the continued expansion in profit margins, a bright spot in a complicated and often frightening world for investors.

And that’s how you should think of this good news: as a bright spot in a complex and unpredictable world that could change anytime.  Assuming that the world remains largely the same, however, the news on profit margins is good for long-term stock investors.

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