Profits Could Weaken as "Perfect Calm" Ends

By Markets Fool.com

The markets are almost eerily calm. Could a storm be coming just over the horizon? Photo: Flickr user 16:9clue.

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Surviving "The Perfect Calm"
One of the most overused tropes of the past two decades is the "perfect storm" -- a phrase that describes a major disaster caused by the confluence of two or more events or forces. When Sebastian Junger wrote his 1997 book about the 1991 nor'easter that took the lives of the crew of the Andrea Gail and popularized the phrase, a "perfect storm" was understood to be a once-in-a-century-or-more event.

Now, on any given day, you can do an Internet search on the phrase and see that nearly anything vaguely new can pass as a "perfect storm." As I google the phrase today, for instance, I see it attributed to a crisis in Yemen, the minimum wage in Oakland, the level of pollen this season, a hallway scuffle in Florida between a judge and a public defender, and, perhaps most accurately, the end of several societies during the Bronze Age. In other words, we've reached a point where, according to the media, perfect storms are absolutely commonplace.

In short, I'm aware that titling any thoughts after such an overused trope invites derision. But the nearly complete absence of stormy weather in our economy -- and, in particular, the action in the domestic stock market -- invites consideration of just how unusual such an occurrence is. It also calls to mind another phrase: "the calm before the storm."

I'd like to point out one variable indicating that the storm has not yet arrived, even though a critical piece of a beautiful calm already seems to have ended.

What we talk about when we talk about an overvalued market
As broad domestic-market indexes keep hitting new highs, a growing number of voices are joining the chorus that the market is either overvalued or due for a correction or a fall, depending on where they fall on the cautious-to-doomsday spectrum. There are any number of data points we can rely upon to tell the story that stocks are overvalued, but most stories depart from a strict P/E-ratio description. After all, using the P/E ratio, the most simple and commonly used indicator of market valuation, stocks do not appear to be tremendously overvalued. At the end of the first quarter, stocks were priced at 16.9 times the 12-month forward consensus analyst expectation for earnings. The 25-year average is 15.7.

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So the forward P/E ratio is a little bit higher than average, but not high enough to spark panic. It's far less than one standard deviation out of whack for the time period mentioned. Of course, you can argue that the past 25 years have generally been dominated by periods of overvaluation and that it is more prudent to look at the valuations of stocks going back 50 years or more. That's certainly a viewpoint worth considering, but it's not fodder for this column. After all, 25 years means something when you're talking about mean-reversion equations.

The strongest argument that the market is overvalued is grounded not merely on earnings, but on how the earnings are composed. There are, to keep it very simple, two components to the earnings: the (top-line) sales and the level of profit earned from those sales. And it is the level of profit margins that is the real concern. Observe the quarterly numbers over the past nine years.

Quarter

S&P 500 Operating Margins

2014

2013

2012

2011

2010

2009

2008

2007

2006

Q4

8.98%

9.76%

8.04%

8.7%

8.68%

7.27%

(0.04%)

5.68%

8.86%

Q3

10.1%

9.63%

8.92%

9.51%

8.95%

6.94%

5.96%

8.06%

9.6%

Q2

10.07%

9.51%

9.41%

9.44%

8.83%

6.19%

6.11%

9.41%

9.35%

Q1

9.76%

9.52%

9.07%

8.99%

8.34%

4.56%

6.25%

9.23%

9.03%

Source: Standard & Poor's.

Consecutive all-time records were set for margins -- off already historically elevated levels -- for five consecutive quarters leading intolastyear's fourth quarter, at which point they hit a significant wall. Less-than-bullish observers (let's not go so far as to call them bears) have been calling for a reversion to the mean for operating profit margins for years now. In fact, they were calling for them in 2006-2007 as well.

Margins are a particularly visible manifestation of the nearly perfect calm. These gently improving margins ticked up just a little bit and a little bit more throughout 2013 to the end of 2014. There was never any boom in the GDP fueling significantly improving earnings numbers. Indeed, you can probably recall that the past several years have been noted for the lack of speed or strength in the economic recovery. Yet improved profit margins hid that weakness, as companies got incrementally better at wringing costs out of their businesses and declining to pursue expensive but unproven potential growth opportunities. The rising profitability has also come at the expense of any increase in employee compensation.

Then the decline in oil prices and foreign-currency effects teamed up (by no means a "perfect storm" level of teamwork) to meaningfully erode margins, along with the profits that came with them, at the end of last year. Reports from the quarter that has just ended will continue to show that margins are being affected, leading to a second consecutive quarter of earnings declines. Whether we'll again see 10% operating margins in the S&P anytime soon -- or ever -- is anybody's guess, but the weight exerted by previously achieved margin levels can't be dismissed out of hand.

Recall that operating-profit margins for the S&P 500 of even 8% were basically unheard of before the past 10 years. Previously, 6%-7% defined the top end of the range that had been established for many decades. A full reversion to the historical mean is something the market has not currently priced in by any stretch, and it would certainly end the perfect calm the markets have enjoyed over these past several years.

Not that I'm predicting such a full reversion, but we've certainly witnessed a wonderfully ascending domestic market, made smoothly possible by companies -- and let's give them credit here -- making more and more money off every dollar of the slowly growing revenue that a modest economy has allowed. Today, amid the perfect calm of a slow-growing, benign economy, investors need to be on the lookout for some break in the perfectly clear weather. When it comes, as it always must eventually, it doesn't need to come in the form of a catastrophe, as it did in 2008-2009. You'll note in the preceding table that margins collapsed from a level of 9.4% to a negative number in the fourth quarter of 2008, marking the first and only time a negative profit margin showed up for the S&P 500. (Now that's a perfect storm.)

I don't expect a repeat of that, nor do many others. But be prepared for margins to take a breather, and for profits to moderate as a result. It doesn't follow that the market must take a big hit as a result, but it does mean that the rewards the market can potentially offer to investors are facing a headwind for a bit.

But be alert
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