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Investment Ideas

Keep a Close Eye on S&P 500 Net Profit Margins

I thought I would write a little piece looking for a fresh perspective: let’s inspect a long-term (25 year) view on three vital indicators of health in the U.S. economy.

Below, a tracking chart from Zacks Research System on 1) the Fed Funds Rate 2) the AAA Domestic Corporate Bond Seasoned Issue Rate, and 3) Real GDP Growth (1-year change).


 

Initial conclusions?

Deep non-financial forces are slowing U.S. growth. Looking over 25 years, one can conclude a stimulus of lower and lower interest rates, whether policy or private, has been fighting an uphill battle against a secular erosion in U.S. GDP growth.

  1. In 1988, the U.S. managed a +4.0% growth rate in real GDP.
  2. Following a downturn, from 1991 to 2000, the U.S. economy climbed back up to +4.5% in real GDP growth, before turning down to just above 0%.
  3. From 2001 to 2007, the economy could barely rebound to +4.0% growth. Then, growth drifted down to a +2.0% rate, before the 2008 downturn.
  4. Following a massive downturn, from 2009 to the present, in this cycle, the U.S. economy could barely reach a +3.0% growth rate on rebound. Now, it is steady, chugging along at a +2.0% rate.

 

  • The U.S. economy has been slowing down for 25 years.

Now let’s turn to net profit margins on the S&P 500 over the last two cycles:



Net profit margins got up to 10.5% in 2000, rising along with real GDP growth rate to +4.5%.  In the next cycle, net profit margins rose above 11.5%. However, it was piggybacking on a lower rebound in GDP growth.

In this cycle? We are barely back up to 10% in net profit margins.

One cannot help but conclude last cycle’s rise to 2007 on oversized S&P 500 profit margins toppled lower growth in real GDP. Oversized profit leveraging in a slower growing U.S. economy was part of the cause of a steep downturn. That is not a new insight. But it gets us up to the present.

In late 2012, we now have a struggle for more earnings and revenue growth on the S&P 500. And, in the last two cycles, a peak in net profit margins preceded the next downturn.

That leads us on to another insight on the present cycle and the present moment.  

We need to see S&P 500 net profit margins either stabilize on a plateau before moving higher, or begin to face the music of a possible downturn. If net profit margins turn lower over an extended period of time, watch out.

I caution against panic, though. An ‘extended period’ of time may be best measured in terms of a year or more.

  • Watching S&P 500 net profit margins really matters! It is one leading indicator of a possible U.S. economic downturn.

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