Corporate earnings reports in coming days will pull stocks higher or lower, as they always do, depending on whether companies meet, exceed or miss forecasts for their revenues and profits. But this time, there’s a better way to get a feel for the market’s health going forward than focusing on expectations for those popular indicators: look at profit margins.
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Corporate ability to hold up near-record profit margins will, in large part, determine whether the S&P 500 rises 8% or more this year, as many major strategists predict, or the bears are proven correct, and the current earnings season will offer the first clues.
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The bullish strategists generally believe that companies can sustain profit margins at levels close to (although not necessarily at) those of 2012. They contend that a couple of key factors that led to better margins are not likely to change in the short term. Those include low wages, low tax payments, long-term cost cutting measures, and very low borrowing rates, as illustrated by the 10-Year Treasury yield.
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Other strategists argue that there are few places for corporations to cut costs anymore, and sluggish or poor economic indicators worldwide will make it difficult to raise revenues to levels needed to sustain profit margins.
Corporations massage profit margin data in various ways and don’t always advertise the result in the earnings release. Trends in margins, as in most earnings data, are more important to investors than the actual numbers. All of that makes charts particularly useful for this metric. YCharts runs charts of many different types of margins, including gross profit margin, operating margin, EBITDA, and net profit margins, which can be seen in the Boeing (BA) chart below. For a quick idea of how margins are going generally this season, keep an eye on the headlines about revenues. If a lot of companies report “disappointing” revenues, there’s a very good chance that their profit margins are too.
The fourth quarter of 2012 was brutal for many – according to FactSet, 78 out of 110 major corporations issued negative guidance about the quarter – and it’s still difficult to determine how much was caused by temporary factors (like fiscal cliff nerves) or more ingrained problems. Investors shouldn’t be surprised by margin squeezes, although perhaps big declines would convince them that the market generally is overpriced. But it will be market-moving news if a lot of companies expanded their profit margins in such an environment.
Of course, the top line numbers as they relate to expectations will always be the focus of earnings days. Market reactions from them, however, are often short-lived. A lot of first quarter 2012 earnings “disappointed” on these measures, but the market went on to end the year up more than 11%. Profit margins aren’t fortune tellers either. But paying attention to them, particularly this year, should offer a little more insight to what lies ahead.
Dee Gill, a senior contributing editor at YCharts, is a former foreign correspondent for AP-Dow Jones News in London, where she covered the U.K. equities market and economic indicators. She has written for The New York Times, The Wall Street Journal, The Economist and Time magazine. She can be reached at email@example.com.