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| A View of Earth from Saturn (Photo credit: alpoma) |
All things considered, most large firms handled the great recession fairly well. Faced with collapsing sales and an uncertain future, most managers became very defensive. They cut staffing to the bone, shut down unprofitable divisions, paid off debt, and raised additional capital if needed. These moves not only helped keep the lights on during the worst of the downturn, but they positioned firms well for the upturn. As the economy slowly began to come back, the leaner and more efficient companies were able to consistently boost their margins and surprise investors, even when revenue growth remained anemic. The charts below show just how high corporate profits have reached, and how profits have hit an all-time high as a percentage of gross domestic product. Shaded areas on these charts represent U.S. recessions.
US Corporate Profits After Tax data by YCharts
US Corporate Profits After Tax as % of GDP data by YCharts
But high levels of profitability can’t go on forever. Eventually firms are going to have to hire more workers, invest in equipment, and face new competitors. Many (including GMO and others) have predicted that margins are due for a mean reversion and that regardless of the strength of the recovery, corporations are going to get squeezed. It’s hard to extrapolate too much from the earnings we’ve seen during the last two weeks, but that squeeze could be starting.
Squeeze Play
To be sure, earnings have not been a disaster so far. According to data from FactSet, of the 98 members of the SP 500 that have reported earnings so far, 70% have exceeded analyst expectations. But of those 98 firms, only 42% have beaten estimates for sales. During the last four years, an average of 59% of firms had beaten revenue estimates at this point in the reporting cycle. Some of those current misses are being driven by unrealistically high expectations and very strong currency headwinds, but some firms are starting to show signs of weakness. Given that most firms have already cut about as much as they can from their organizations, the drop in sales is likely to eventually lead to a drop in profit as it will be harder to cut deeper to keep profit growing. ... Continue to read.
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