Corporate Profit Margins Have Grown Fat, But the Recovery Can’t Last

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Given current trends, with an eye toward historical patterns, the economy likely will keep growing into 2016 – and the stock market with it. After that, look for much less robust results. Why? For one thing, the tailwinds of loose monetary policy will no longer be at our back.

The U.S. economic recovery recently turned five. While much progress has occurred, significant economic slack endures. The U.S. has added only 500,000 additional workers since the end of 2007. Real wages have barely budged. Inflation-adjusted retail sales are just 3 percent above 2007 levels. Auto sales, while rising, have not fully recovered. And housing starts must rise more than 50 percent to match the 50-year average.

But based on historically reliable metrics, the economic expansion should last for at least another year or two. The Federal Reserve will complete its bond-buying stimulus program, called quantitative easing , in a few months but will hold interest rates low for a considerable time. That will encourage further growth in housing, autos, employment, and consumer spending. And even when the Fed does start to raise rates, the first several increases should have little, if any, negative economic impact.

While the economy has struggled to post meaningful gains since 2007, after-tax corporate profits are up more than 50 percent. The rise in profits is the driving force behind the broad-based equity advance. U.S. after-tax corporate profits eclipsed $1.7 trillion in 2013, a figure representing over 10 percent of the nation’s gross domestic product and the highest net profit margin in the country’s history.

High profit margins have important implications for valuation and future expected returns. Why? Jeremy Grantham, co-founder of Boston-based asset manager GMO, put it best, “Profit margins are probably the most mean-reverting series in finance.” Mean reversion, or regression toward the average, is the concept that if a data point is currently at an extreme level, it will tend to move closer to its average on future measurements. Historically, economy-wide net profit margins average 6 percent.

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