Are Corporate Profits -- and Stocks -- Doomed to Fall?

Even as the stock market achieves record high upon record high, one of the concerns that surfaces periodically among finance professionals and the financial media is the state of corporate profit margins, which are themselves at record levels.

As S&P senior index analyst Howard Silverblatt noted on Nov. 7: "With over 90% of the issues [in the S&P 500 ] reported, Q3,'13 is set to post a new operating [margin] record. Margins are at their record high -- the record is 9.60% in Q3,'06; with the current reading 9.65%."

The following table illustrates this situation with three Dow Jones Industrial Average components, IBM , Walt Disney , and Boeing . These are mature, stable businesses, and one would not expect to see significant changes in their core profitability:

 

Normalized Income Margin, Trailing 12 Months

Average Normalized Net Income Margin, Last 10 Years

IBM

13.1%

10.3%

Walt Disney

12.6%

10.1%

Boeing

4.7%

3.8%


Source: S&P Capital IQ.

Aren't high profit margins something investors should rejoice over? Yes and no. The trouble is that, in aggregate, profit margins tend to be mean-reverting, i.e., periods in which they rise above their long-term average tend to be followed by periods in which they fall back toward the average. All other things equal, lower profit margins imply lower profits, and that is a threat to stock values. As Gavyn Davies blogged in the Financial Times last month:

In the US case, a return to normal for the labor share [of profits] in national income, from 59 to 62 per cent, could reduce the return to shareholders (domestic corporate earnings after depreciation and interest payments) by more than 25 per cent on a permanent basis, a change which current equity valuations could not possibly survive.

But before you start worrying that profit margins are set to collapse, you should know there are several reasons for which the current "record" levels might not be all they're cracked up to be right now. In the following video, Fool One analyst Morgan Housel and Fool contributor Alex Dumortier explain why companies' profitability may not be as far above average as it appears.

This tech stock is expanding its cash profit margins -- and growing like a weed
Profit margins for a broad index mean revert on a cyclical basis, but this incredible tech stock is riding an important secular trend, and growing twice as fast as Google and Facebook, and more than three times as fast as Amazon.com and Apple. Watch our jaw-dropping investor alert video today to find out why The Motley Fool's chief technology officer is putting over $100,000 of his own money on the table, and why he's so confident this will be a huge winner in 2014 and beyond. Just click here to watch!

The article Are Corporate Profits -- and Stocks -- Doomed to Fall? originally appeared on Fool.com.

Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool recommends Walt Disney. The Motley Fool owns shares of International Business Machines and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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