Corporate Profit Margins Diverge From Equity Market Index

January 16, 2020

Source: Bloomberg Source: Bloomberg

The December employment numbers revealed that ADP private payrolls increased by 202,000, higher than consensus expectations of 160,000. Nonfarm employment increased by 145,000, slightly lower than the anticipated 160,000; and, the unemployment rate held steady at 3.5% — a 50-year low. The job market appears stable from looking at these numbers; however, average hourly earnings increased only 2.9% year-over-year, showing a cool down in wage growth.

The decline in wage growth is not the only factor indicating a weaker job market. When we look at the employment data, there are three leading indicators of employment conditions. The first is U.S. job openings, a number provided by the Bureau of Labor Statistics, which reflects nationwide occupational vacancies including newly created and unoccupied positions. The yearly growth rate of job openings has declined, which indicates companies are more reluctant to hire and is a negative sign for future nonfarm payroll numbers. The second factor is U.S. continuing jobless claims, which tracks the total number of people who have filed claims to receive unemployment benefits from the Department of Labor. This number reached a 10-year high in December and the growth rate turned positive, which indicates it’s taking longer for unemployed Americans to find employment and is a negative sign for future unemployment rates. The third leading indicator is working hours. Due to the high costs of hiring and firing, companies tend to reduce working hours as the first step to reduce labor costs. If we look at The Conference Board’s report on average weekly production hours in the manufacturing sector, we see this number continued to decline in 2019. All three leading indicators point to a weakening U.S. job market.

One reason, and possibly the most important, for the weaker employment data is tight corporate profit margins. Corporate profit margins are measured by using net operating surplus as a percentage of gross value added of nonfinancial corporates from the Bureau of Economic Analysis (BEA). As we can see from this week’s chart, corporate profit margins have been declining and recently reached post-financial crisis levels. Previously, high corporate profit margins were a strong contributor to the equity market rally and largely reflected lower labor costs benefited by globalization, lower tax rates due to tax reform, lower borrowing costs and more dominant firms resulting from increasing merger activity. However, this trend is clearly not continuing, as corporations are facing pressured wage growth as a result of a tight job market, an equilibrium of globalized labor market costs and fewer tax-rate arbitrage opportunities.

Historically, corporate profit margins would trend with the S&P 500 Index, but has diverged in recent years. There are a few factors that could be driving this divergence, which is why I consider corporate profit margins a better indicator of market conditions. The first reason is manipulation of earnings per share (EPS) in equity markets using accounting and share buybacks. We have seen an acceleration in share buybacks in recent years, contributing to a higher EPS. The second reason is higher equity valuations. Stocks are valued higher in a low interest rate environment. The third reason, and probably most important, is that equity market indices only represent large companies. Even the small cap companies in the Russell 2000 Index have over 3000 employees, on average, while about 60% of Americans are employed by firms with fewer than 1000 workers. Profit margins for big companies are good, as they generally benefit from more pricing bargains and lower labor costs through globalization. However, achieving higher profit margins is tougher for smaller companies. As a result, equity market indices are using a biased sample of U.S. companies compared to corporate profit margin numbers from the BEA.

Corporate profit margins have a bigger impact on consumer spending than the equity market. The wealthiest Americans dominate the U.S. stock market, but their marginal propensity to consume (MPC) is low. The majority of people who have a high MPC own a small percentage of U.S. equity and, therefore, benefited much less from the equity market rally. Tight corporate profit margins can lead to a slower hiring process and higher unemployment rate. In this case, consumers are less willing to spend, which results in lower consumer spending. This, along with lower capital investment, compresses corporate profit margins even more. Historically, tight corporate profit margins have always been followed by a recession, accompanied by high inflation and interest rate hikes from the Federal Reserve (Fed). However, it might be different this time as the inflation level is tame and the Fed has shown no indication of a hike in its latest statement.

Key Takeaway

I consider recent weakened employment data to be a result of tighter corporate profit margins. Corporate profit margins are an important indicator of market conditions because it drives employment, capex growth and consumer spending, as well as the stock market. A deterioration of corporate profit margins would raise the odds of a recession. There has been a divergence in corporate profit margins and equity market indices in recent years, driven by share buybacks, higher equity valuation and large company bias in equity indices.

Even though a recession has historically followed low corporate profit margins, the economy remains stable as the inflation level is low at this time. I will be more cautious if inflation picks up as the previous year's wage growth flows in, food prices move higher and oil prices continue to increase. I will keep an eye on the next release of corporate profit data from the BEA at the end of this month.


Tags: Inflation | Employment data | Jobs report | Equities | Valuations | Share buybacks | corporate earnings

< Go to Chart of the Week

The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice.  The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete.  Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements.  Actual results may differ significantly.  Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.

Investing involves risk, including possible loss of principal.  Past performance is no guarantee of future results.  All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.

High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.

All trademarks are the property of their respective owners. This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission.

Subscribe to Our Publications