Why High Profit Margins Could Be Bad for the Bull Market

With the Fed’s self-fulfilling “wealth effect” taking hold…

3 Year Performance of Major Stock Indexes

…both the NASDAQ and Russell 2000 indexes reaching heights above April 2008…and talk of QE2 ending before the June 30 deadline, we begin today with a question: What is the most likely pin to prick this 24-month bull?

“Profit margins,” comes the plausible reply from Horizon Asset Management.

“Profit margins are near peaks,” writes Chris Mayer parsing the report into nuggets useful for our purposes. “Investors tend to like companies with fat profit margins, but high profit margins are like honey pots that attract competitors.

“They are rarely sustainable for long.

“What is more important for stock prices is not the profit margin itself, but the direction they move. Rising profit margins goose stock prices in wonderful ways, but declining profit margins are a tough anchor to overcome.”

The problem today is that most of the big blue chips report record profit margins. Let’s look at the tech sector. Here are the profit margins of top 10 tech stocks on the NASDAQ-100, listed in order of market cap.

Nasdaq 100 Top 10 Technology Stocks

The top 10 techs in the market are sporting an average profit margin of nearly 26%. That number is “without any historical precedent whatsoever,” Horizon notes.

“Profit margins are extremely high and unlikely to stay there,” says Chris, “which ought to lead to earnings disappointments down the road – hence Cisco’s one-day drop of 16% recently.”

The phenomenon extends well beyond techs. “There are quite a few companies,” in the top 50 stocks in the S&P 500, Horizon’s report says, “with very high absolute profit margins.”

The nontech list is notable: Coca-Cola, Schlumberger, McDonald’s, Occidental Petroleum and Freeport-McMoRan Copper & Gold “all have the common feature of after-tax net profit margins well in excess of 20%…

“In general, a 20% profit margin for any company is a historical rarity.”

“In some ways,” Chris observes, “the surge in profit margins is what you would expect to see in the early phases of a recovery. Companies cut costs going in a downturn. Then, as sales rise, there is a big boost to the bottom line, as costs have yet to catch up.

“Today, though, I doubt many of these firms have much more to cut.

“Instead, the focus is now growing sales and taking business from competitors or defending an existing business. The focus, too, is how to deal with rising raw material costs. All of these put enormous pressure on margins.

“We should expect to see them fall.”

Addison Wiggin
for The Daily Reckoning