Is the Profit Margin Set to Revert to the Mean? (excerpt)

There’s a raging debate over the profit margin--not so much in Boston, where I visited our accounts last week, as between the WSJ and Barron’s. In his 3/27 WSJ column, Justin Lahart noted that Thursday’s GDP report showed that the profit margin rose to yet another record high of 11.1% during the fourth quarter. He notes that most of the factors that have contributed to this development could be reversed: “Keeping costs low by refraining from hiring or not replacing equipment can only be done for so long, though. And long-term interest rates look more likely to rise than fall over the next year. Losses to offset taxes, too, eventually get used up.”

In his 3/29 Barron’s column, Randy Forsyth reviews the contrary views on this subject held by Robert Buckland, Citigroup's head of global equity strategy. Randy summarizes Buckland’s main point as follows: “Of course, companies must invest to generate future returns, but overinvestment drags down profitability, growth, and employment.”

I’ve been arguing that margins are likely to remain high because I expect companies to continue to be cautious about expanding their capacity and payrolls. However, I am becoming concerned that deflationary forces (more competition and more technology) could depress margins from the top down.

Needless to say, the record high in the profit margin is bound to continue to inflame the income inequality crowd. During Q4-2013, wages and salaries in compensation accounted for just 48.9% of national income, the lowest share on record. Total compensation (including supplements) fell to 60.7% of national income, the lowest since Q4-1951. Of course, the data are pre-tax and before social benefits, which significantly reduce income inequality.

Today's Morning Briefing: Boston Views. (1) Cold, but calm, in Boston. (2) Mostly bullish, but seeking value. (3) The expansion is mature. (4) The capital-spending debate. (5) Why hasn’t ultra-easy monetary policy been inflationary? (6) Could it be deflationary? (7) Italian and Spanish bond yields anticipating ECB response to deflation risk. (8) Japanese bond yields show skepticism about Abenomics. (9) The profit margin debate. (10) What will it take to revive EMs? (11) Rational and Irrational Exuberance. (12) Putin’s melt-up or meltdown? (More for subscribers.)

Rotating Into Systems Software (excerpt)

Yesterday, I noted that the recent decline in the so-called “momentum” stocks--particularly in the S&P 500 Biotechnology, Internet Retailing, and Internet Software & Services industries--has raised fears that this might signal a market top. I noted that the S&P 500 remains near record territory despite the weakness in these stocks and that investors may simply be rotating into stocks with lower valuation multiples.

I noted that Financials seem to be benefitting from this internal correction. Yesterday afternoon, we learned that the Fed rejected the capital plans of five large banks and approved 25 as part of its annual stress tests. Companies must pass the test to receive approval to pay more dividends and to buy back shares. The results set the stage for several banks to do just that after years of restraint following the financial crisis. The S&P 500 Bank Composite Index is up 6.9% ytd, and should continue moving higher.

Also benefitting from the correction in the momentum stocks are the mature tech stocks that had been the high-flyers during the tech boom of the 1990s. The S&P 500 Systems Software stock price index (CA MSFT ORCL RHT SYMC) is up 3.6% ytd to a new bull market high and only 21.5% below its March 23, 2000 all-time high. Back then, the forward P/E of this industry was 49.4. Now it is 13.4. Back then, industry analysts predicted long-term annual earnings growth of over 25%. Now they are projecting 9%.

Today's Morning Briefing: Perspectives on Europe. (1) Europhiles in Boston. (2) Is “Stay Home” too consensus? (3) ECB ready to do more of whatever it takes. (4) Bundesbank’s hawk cooing like a dove. (5) Eurozone’s forward revenues and earnings still falling. (6) From momentum stocks to mature ones. (7) Fed lets more banks pay more dividends. (8) Investors rotating into Systems Software and Semiconductors. (9) Focus on overweight-rated S&P 500 Financials. (More for subscribers.)

Biotech Has a Hiccup (excerpt)

The S&P 500 Biotechnology stock price index (ALXN AMGN BIIB CELG GILD REGN VRTX) peaked at a record high on February 24. It is down 10.5% since then through yesterday’s close. It is still up 208% from its 2011 trough, when the forward P/E fell to 10. This valuation multiple is now 22.0.

Driving valuations higher in the industry since mid-2011 has been an amazing increase in industry analysts' expectations for short-term and long-term earnings growth. The former has tripled to over 30%, while the latter has doubled to almost 25%. The recent correction in Biotechs was triggered by concerns that the government will pressure the industry to reduce the prices of some of its higher-priced products.

Today's Morning Briefing: Internal Correction. (1) S&P 500 remains at record high despite everything. (2) FSMI rebounding. (3) Priciest industries a bit less so. (4) A good excuse for taking some profits out of Biotech. (5) Internet Retailing is full of hot air. (6) Internet Software is cheaper, but not cheap. (7) Is there a shortage of growth stocks? (8) Growth stocks tend to attract attention and well-financed competitive startups. (9) Internal corrections broaden the bull market. (10) Financials may be too cheap now that they are so regulated. (11) The parable of Alibaba and Tencent. (More for subscribers.)

Purchasing Managers Indexes Mostly Upbeat (excerpt)

Also providing a bit of lift to stocks yesterday morning was Markit’s latest batch of flash M-PMIs. The US manufacturing index edged down from 57.1 during February to 55.5 during March, but remained solidly above 50.0. Both the output and orders component indexes remained strong at 57.5 and 58.0.

Markit also noted: “Meanwhile, there were signs in March that supply chains started to recover from adverse weather disruptions and subsequent bottlenecks earlier in the year. This was highlighted by the seasonally adjusted suppliers’ delivery times index rising sharply over the month to its highest level since June 2013. Although the index remained below the neutral 50.0 threshold, the month-on-month index rise was the greatest since the survey began in May 2007.”

Markit also found ongoing strength in the Eurozone’s manufacturing sector. Although the area’s M-PMI edged down to 53.0 from 53.2, the output component upticked from 55.3 to 55.4. Deflation remains a potential problem: “Input costs showed the smallest monthly rise for nine months, while prices charged by manufacturing and service providers fell on average to the greatest extent since last July. Lower prices were often attributed simply to the need to compete to win business.”

Stocks also rose yesterday morning despite continued weakness in China’s flash M-PMI. It fell from 48.5 in February to 48.1 in March, an eight-month low. It has declined for the past five months from a recent peak of 50.9 during October. The output component was even weaker, falling from 48.8 last month to 47.3 this month. That’s an 18-month low. Apparently, investors believe that bad news is good news in China since the government is likely to scramble to stimulate more growth.

Today's Morning Briefing: No Place Like Home. (1) The Russians are coming, maybe. (2) El-Erian warns about geopolitical risks. (3) Hilsenrath offers calming spin on Yellenomics. (4) Lots of flashy M-PMIs. (5) Putting a positive spin on China’s weakening M-PMI. (6) Round 2 for Abenomics? (7) Has the good news been discounted in the Eurozone? (8) China has an IT bubble. (9) Japan’s stock sectors waiting for the next leg up, or down. (10) US S&P 500/400/600 forward earnings are global standouts. (More for subscribers.)

Stocks Continue to Follow Bull Market Script (excerpt)

Earlier this year, the bears noted that the DJIA might be following the 1928-1930 Great Crash script. Fortunately, it hasn’t play out that way so far. Now the bears are focusing on 1938-1939, when Hitler invaded Austria, Czechoslovakia, and Poland.

The concern is that current geopolitical developments are eerily reminiscent of that period. I noted a week ago that in October 1938, Hitler marched unopposed into Sudetenland a month after Britain and France gave him this territory that was part of Czechoslovakia. The Sudeten Nazi Party had set the stage for this annexation by instigating strikes and riots, which were shown in German newsreels as evidence of Czech atrocities against German-speaking Sudetens. Hitler threatened war unless he was appeased, which he was at the infamous meeting in Munich. Putin seems to be following the same script in the Ukraine.

Nevertheless, the S&P 500 rose to a new intra-day record high of 1883 on Friday before closing at 1866. It managed to gain 1.4% for the week, following the previous week’s 2.0% decline. That’s despite last Wednesday’s 0.6% decline in response to Fed Chair Yellen’s off-the-cuff statement that the Fed might start raising interest rates six months after QE is terminated probably by the end of the year. That would mean that rates will start rising around mid-2015.

Stocks rebounded 0.6% the next day, Thursday, as investors realized that Yellen’s forward guidance depends on inflation rising back to 2% and the unemployment rate falling probably closer to 5.5%. That might take longer to happen than mid-2015. In any event, the Fed's latest “dot plot” showed that in the latest economic projections of the FOMC’s participants, the federal funds rate is expected to be just 1.0% at the end of 2015, hardly an impediment to higher stock prices.

So far, the stock market is continuing to follow a bull market script similar to the bull markets that started in 1982 and in 1990. That’s mostly because forward earnings for the S&P 500/400/600 continue to rise to record highs.

Today's Morning Briefing: Stock Market’s Script. (1) DOE may or may not move faster on LNG. (2) What do Nova Scotia and Israel have in common? (3) Europe hooked on Russian gas for now. (4) Russia is a big oil producer too. (5) Monitors going to Ukraine. (6) Stocks still following bullish, not bearish, scripts. (7) Forward earnings still moving forward. (8) Forward earnings yield exceeds bond yield driving buybacks. (9) Bull refuses to correct. (10) The Fed’s third mandate. (11) Yellen’s dashboard now includes wages. (12) “Divergent” (+). (More for subscribers.)