NIPA’s “all-economy” profit margin declined a bit in Q4—which typically peaks before SPX profits—and that falloff coincided with the economy officially reaching full employment, based on the CBO’s Nominal GDP Output Gap. When the Output Gap has flipped positive (like in Q4), corporate profit margins usually come under immediate pressure.
In early 2018, we thought the market was expensive, but certainly not a bubble. Today, the trouble is not just high P/E multiples, but the sustainability of the “E” itself—with profit margins nearly 20% higher than ever before. Whether one believes U.S. Large Caps are engulfed in a bubble or not, we have a P/E ratio for you.
The environment where massively above-trend federal outlays have generated massively above-trend readings in both current and projected S&P 500 EPS, the idea of normalizing EPS over a period as long as five years might seem hopelessly out of touch. But it’s during times of extraordinary conditions—both good and bad—that render this work especially valuable.
Market momentum now seems to outweigh simple math in the minds of most investors, and we are not entirely immune. Today our tactical funds are positioned with net equity exposure of 50%, the midpoint of the normal 30-70% range. That’s a higher allocation than if we considered only business cycle dynamics and equity valuations.
December’s Of Special Interest provided a recap of our Asset Allocation team’s view of small cap equities, suggesting that small caps had underperformed and reached a valuation discount that made them an interesting contrarian value proposition. Several clients responded with follow-up questions, wondering if the discount valuation of small caps was offset by their typically weaker business models.
Corporate profits were outstanding last year, but even the benefit of a 40% cut in the top income-tax rate wasn’t enough to lift the net profit margin back to the all-time high of 10.6% established in early 2012. Still, the latest 10.0% figure is more than a percentage point above the 2007 cycle high and about two points better than any other cycle high.
A massive drop in corporate tax payments lifted the third quarter NIPA profit margin back to the 10% level for the first time four years. But while we try not to always view the glass as half empty, we find it troubling that margins remain well-below their 2012 highs (10.6%) in spite of this one-time windfall.
We revisit commentary we published in 2015 regarding the late-2014 oil price crash and review why, at that time, we believed oil prices could stay at depressed levels for a longer period than most expected. Additionally, we advise avoiding two Energy sector segments: companies with high balance-sheet risk, and Energy Royalty Trusts.
Government accounting on everything ranging from the CPI, to the budget deficit, to even the unemployment rate is constantly assailed as being too rosy. So when a government report occasionally paints a less optimistic picture than the consensus one, we’re inclined to sit up and take notice (especially when we agree with it).