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Profit Margins Have Peaked

Posted by Jeremy Merchant on May 1, 2015 5:00:00 PM
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In mid-2009, our portfolios moved to an equity overweight position as we noted that the markets had the potential to experience a "business led recovery" that might drive the equity markets higher. Looking back over the last 6+ years, today's markets are certainly trading higher thanks to strong corporate profits.

The mid-2009 adjustment was somewhat dramatic at the time; however, we noted that with interest rates were at (or near) zero, businesses had the opportunity to dramatically reduce costs and thus propel their profit margins higher. This could (and did) occur, regardless of what happened to their top-line growth (revenues).

While the average retail investor was looking for a "consumer-led recovery," we noted that the business led recovery would eventually drive the markets to higher valuations. Today we see that the market is no longer undervalued. In fact, based on forward earnings the market is currently trading at over 17.5x. This is slightly above the long term average equity multiple of 15.5x.

As you know, our portfolios are no longer overweight equities. We are now in an approximate neutral posture with regards to our equity-to-bond ratios. Today we see that corporate profits for this business cycle may have peaked. We are starting to see companies spend again via mergers and acquisitions and capital expenditures activity which is a good thing. This means corporations are starting to loosen their purse strings which may eventually translate to stronger consumer activities. This also means that corporate profit margins are declining, as companies start to spend again. We can see this in the graphic below on corporate profit margins.

Corporate Profits as a Percentage of GDP


Improved Employment Figures

Corporate spending leads to improved employment figures, which we are now seeingwithinthe market. In fact, the headline unemployment rate of 5.5% is now below its 50-year average of 6.1%. We are now seeing signs that the improvement in employment is leading to wage and salary increases across most sectors of the economy. This wage and salary improvementis visible in the below graphic.

 

Wage and Salary Costs by Sector


Monitoring Commodities

Trends in wage and salary growth are a leading indicator for inflationary pressures. While our domestic economy does not have inflationary pressure yet, we note that pressures are increasing slightly. This has led our Investment Policy Committee to re-explore our allocation to commodities.

As we have mentioned before, we have been underweight commodities for the past few years. This has been a good decision as commodities have underperformed compared to the general domestic equity market in recent years. If and when inflationary pressures increase, expect us to re-allocate to the commodity market in a material way.

In the near term, we are looking at the commodity market for trends within the energy sector. With such a dramatic decline in energy prices over the past year, we may consider introducing an energy position back into the portfolio sometime over the summer months.

As we monitor trends in corporate profits, valuations, wage growth and inflationary pressures, expect us to keep you updated on any proactive adjustments we execute in the portfolios.

 

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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security. 

Topics: Investment Updates