The following chart from Oppenheimer( found via Street of Walls) reveals a very frightening picture. Profit margins are at an all time high going back to data from 1979. Margins which hit a low of approximately 5% in the early 1990s are now at 12%. The previous high was at 10%, reached in 06-07, at the peak of the housing bubble. The average level between now and 1979 is between 6-8%.
Joel Greenblatt claimed at the last Value Investing Congress that reversion to the mean does not apply to profit margins. He did not really explain why, and we fail to see the logic for the following reason.
Inflated profit margins are due to high revenue at peaks of a cyclical and temporary cost cutting measures. On the revenue side, companies are reporting record high earnings in large part due to lower borrowing costs as a result of Fed policy and growth overseas. This growth is slowing down in both the Emerging markets and in Europe.
On the cost cutting side, companies have been squeezing productivity out of their workers at record levels. If the economy continues to improve this will be impossible to maintain. There is a limit to how much one person can produce, whether, it is in manufacturing or finance. People will not be able to complete the job and/or switch to a different firm.
If profit margins return to their mean, which we think will eventually happen; corporate earnings will be cut in half. Assuming the market is largely effecient this would mean an eventual drop of 50%. This is assuming the market is fairly valued, which we have questioned based on current valuation metrics. While we have no idea when margins will decrease, and multiples will reach lower levels; we think it is very likely that it will happen in the future.
See chart below for data: