VALUATIONS - Gap between price inflation and unit labor cost inflation Drives Profits

The Most Important Driver Of Profit Margins 10-30-13 BI

One of the hottest debates among experts covering the markets and the economy is over the sustainability of record high profit margins.

Goldman Sachs' Jan Hatzius offered his forecast for margins in his "10 Questions for 2014" note.

"Will profit margins contract?" asked Hatzius. "No."

"As shown in Exhibit 10,

"The most important driver of profit margins is the gap between price inflation and unit labor cost inflation. When prices grow faster than unit labor costs, firms typically manage to raise their profit margins, and vice versa. In our view, the price/ULC gap is likely to move back into slightly positive territory in 2014."

Hatzius expects wage growth to stay low at least in the near-term.

"[T]he underlying trend calculated from the three primary measures of hourly wages—average hourly earnings, the employment cost index, and compensation per hour—is still only growing 2%," added Hatzius. "Going forward, we expect only a modest acceleration to perhaps 2.5%. Meanwhile, we expect productivity growth to reaccelerate to 1.5%-2%. Together, these numbers imply unit labor cost growth of 0.5%-1%, which would be slightly below the rate of price inflation of 1%-1.5%."

Labor market slack is one of the main reasons why economists believe inflation will stay low for a while. But getting back to profit margin dynamics, we know that wage growth is only part of the story.

"Of course, the price/ULC gap is not the only driver of margins," continued Hatzius. "But other factors are also likely to look reasonably friendly.

We expect foreign profits to improve in 2014 as the global economy gathers some momentum, and see no major changes in corporate income taxes or financial profits."

VALUATIONS - Historically Elevated Margins

Corporate profit margins are at all-time highs. The stock market's bulls and bears are willing to agree with this fact. But that's about it.

The bears are convinced that margins are doomed to mean revert. Among other things, they note that companies are no longer able to squeeze further productivity out of their workforces. They also warn that rising interest rates mean higher interest expenses.

The bulls will acknowledge that margins are at risk of pulling back especially if revenues fall or if the economy goes into recession.  But for now, they don't see much giveback. Furthermore, they believe that margins are in a structural upswing as companies have slashed their exposures to debt and increased their exposures to low-cost, high margin overseas regions.

Blackstone's Byron Wien thinks this is a crucial story.

In fact, when Business Insider asked Wien for what he considered to be the most important chart of the year, he sent us a chart of historical profit margins on the S&P 500.

"This chart worries me," said Wien. "Profit margins are at a peak and they appear to be rolling over. This could mean trouble for 2014 earnings."

Blackstone, WisdomTree

VALUATIONS-

JEFF SAUT: I Don't Buy The Profit Margin Compression Argument, I Think The S&P 500 Can Go To 2,000 01-04-14 BI

"Year-end letters are difficult to write because there is always a tendency to discuss the year gone by or, worse, attempt to forecast the coming year," said Raymond James' Jeff Saut earlier this week. But perhaps begrudgingly, Saut offered his forecast anyway.

He warms into it by first reminding us of the various psychological hurdles in recent years:

Speaking to the news backdrop, consider this. For the past two years the markets have been confronted with numerous issues.

• The debt downgrade,
• The fiscal cliff,
• The sequester,
• The government shutdown,
• Dodd-Frank,
• Rumors China would implode,
• The call that interest rates would skyrocket,
• Europe’s debt crisis,
• A potential U.S. debt default,
• Fukushima,
• The Arab Spring,
• Iran,
• North Korea,
• Iran,
• Egypt,
• Syria, etc.,

... yet the equity markets traded higher. In contrast, except for Obamacare, this year could be relatively, news-wise, trouble free. Moreover,

• Bond yields have already risen and are unlikely to move much higher in the short/intermediate term,
• Tapering has been announced,
• GDP and earnings guidance has been raised,
• There is more political cooperation (budget deal, Yellen, WTO deal, EU bank accord, bailouts over, Mexico reform, etc.),
• The American Industrial Renaissance is alive and well,
• Our oil independence is almost assured, and
• The central banks remain accommodative.

To this accommodative point, it has been proven that quantitative easing lifts stock prices; and despite the taper announcement, the Fed’s balance sheet should still expand by some $435 billion in the new year (front-end loaded).

...there has been a very tight correlation (R2) between the expansion of the Fed’s balance sheet and stock prices since 2009.

If the Fed expands its balance sheet by another 12% over the coming year, it is conceivable the SPX could increase by another 12%. That would also be consistent with the S&P’s bottom-up, operating, earnings estimate increase of ~13% year-over-year ($122.11e vs. $107.40e).

And it's not just about Fed balance sheet expansion. Saut sees plenty of bullish fundamentals driving stocks higher.

Plainly, the U.S. macro uncertainty is falling with the budget deficit falling to a six-year low. That glide path should extend into 2014 with the CBO projecting a further drop in 2015 to a deficit of only 2.1% of GDP. Accordingly, I think a lot of things could indeed go right in 2014. The slowdown in housing, due to the increase in mortgage rates, should reverse now that mortgage rates have stabilized. A recent data point would be Lennar’s (LEN/$39.55/Strong Buy) admission – best month of the quarter was November in terms of sales and pricing. The capital equipment cycle (cap ex) should strengthen in 2014. In talks with companies’ senior management teams, they are telling me “We have put off investments in cap ex as long as we can because ‘things’ are just plain wearing out.” Furthermore, credit conditions are improving, loan demand is slowly picking up, M&A activity is increasing, dividends and buybacks are on the rise, profits are decent, inflation is contained, money is rotating out of most bond funds and (at the margin) into equity funds (given the amount of money that has flowed into bonds since 2008, this rotation has a lot further to go), the bad performance figures for 2008 are about to disappear from asset managers’ five-year track records, and the list goes on. All of this should make for interesting discussions in the new year when financial advisors meet with their clients to talk about future asset allocations. Unsurprisingly, most investors remain underinvested in equities...

Saut thinks it's possible we go straight up without a meaningful sell-off for a while.

As we begin 2014, I think the rally extends without much of a pullback. In fact, my sense is we could travel into the 1900 – 2000 zone on the SPX before succumbing to any meaningful correction. Right now the inflation-adjusted all-time high for the SPX is around 2060, but I doubt if we can make it there before getting some kind of “hiccup.”

Currently, the SPX is better by 31.3% YTD and up about 40% from the June 2012 low without any meaningful correction. The historical median drawdown following such a rally is between 6% and 7% over the next three months and between 10% and 12% sometime during the next 12 months.

And since it's one of the hottest debates in the market these days, Saut offered his position on record high profit margins.

Price/Earnings (P/E) multiple expansion has contributed heavily to the upward path of the equity markets over the past few years and there has been a lot written about that. In 2014 it is doubtful P/Es will expand very much because of the tapering announcement and fears interest rates will rise. Yet even if the SPX just trades at its current P/E multiple (17x), it suggests an SPX price target of 2076 by the end of 2014 if the earnings estimates are anywhere close to the mark. Of course that brings about cries that elevated profit margins cannot remain where they are, and therefore must revert to their historic mean hurting earnings, an argument from the negative nabobs we have heard since 2010; and I just don’t believe it.

• Many companies are moving their IT needs to the “cloud,” which saves a huge amount of money permitting margins to stay wide.
• Then there is the change in the composition of goods produced in this country that has moved from low margined goods to higher margined goods like jet engines.
• Or, how about the accounting term “income from affiliates,” which means a parent company has a minority stake in another company that brings in income but doesn’t record revenues associated with that stake, suggesting 100% margins.

So, no, I do not buy the margin compression in 2014 argument.

So overall, he's bullish