Fattening profit margins have enabled U.S. corporations to generate record profits despite modest revenue growth in the wake of the financial crisis.
Now, everyone wants to know if and when these margins will contract.
The bulls generally argue that margins have been in a secular uptrend thanks to technology, increasing overseas exposure, and lower interest and tax expenses among other things. Any contraction would be cyclical and short-term.
The bears take a step back and come from more of a big picture standpoint. They argue that margins will revert to a mean largely for mean reversion’s sake. The most vocal and prominent profit margin bear is probably John Hussman, whose work has been supported by James Montier, Albert Edwards, Byron Wien, Jeff Gundlach, and even Business Insider’s Henry Blodget.
There are many ways to characterise and measure profit margins
The profit margin chart most frequently cited by the bears is corporate profits after tax as a percentage of GDP (CPATAX/GDP). Here’s Hussman’s version:
As you can see from the blue line, Hussman’s ratio has blown out, and it looks like gravity is soon to catch up.
Unfortunately, this chart “is an illusory result of flawed macroeconomic accounting,” argues Jesse Livermore of Philosophical Economics in a must-read blog post. Basically, he explains, this ratio assumes that overseas profits have a profit margin of infinity. He explains (emphasis added):
The expression CPATAX/GDP contains an obvious distortion. CPATAX is a “national” term — it refers to the after-tax profit of all U.S. resident corporations, whether that profit is earned domestically, or from operations in a foreign country. GDP, in contrast, is a “domestic” term — it refers to the total gross output (and therefore the total gross income) produced (and earned) inside the United States, whether that income is earned by U.S. residents or by foreign entities.
Notice that if a U.S. corporation earns a profit from affiliate operations abroad, the profit will be added to the numerator of CPATAX/GDP, but the costs will not be added to the denominator, as they should be in a “profit margin” analysis. Those costs, the compensation that the U.S. corporation pays to the entire foreign value-added chain — the workers, supervisors, suppliers, contractors, advertisers, and so on — are not part of U.S. GDP. They are a part of the GDP of other countries. Additionally, the profit that accrues to the U.S. corporation will not be added to the denominator, as it should be — again, it was not earned from operations inside the United States. In effect, nothing will be added to the denominator, even though profit was added to the numerator.
Because nothing is added to the denominator, these foreign earnings effectively come with an infinite profit margin.
Of course, the opposite happens for foreign companies operating in the U.S.:
Similarly, if a foreign corporation earns a profit from operations inside the United States, both the costs and the profit will be added to the denominator of CPATAX/GDP, but the profit will not be added to the numerator. That profit — which accrues to the foreign corporation operating domestically, and is part of U.S. GDP — is not part of CPATAX.
…So, in effect, CPATAX/GDP will fall as if the sale had occurred at a 0% profit margin. No profit on positive revenue.
So, one type of profit wrongly increases the ratio and the other wrongly decreases it. One inevitably asks: by how much do these two types of profits offset? It turns out that the distortion is quite signifcant:
Over the last 50 years, U.S. company profit earned abroad has increased by a much larger total amount than foreign company profit earned in the U.S. The difference has become especially significant in the last 10 years, as foreign sales have boomed. At present, U.S. company profit earned abroad is around $665B, whereas foreign company profit earned in the U.S. is only around $250B — a difference of around $400B.
So it’s clear that CPATAX/GDP is being wrongly inflated. This differential has been trending higher for decades. Here’s Livermore’s chart:
All of this red you see above represents the massive distortion to the CPATAX/GDP ratio everyone loves to pass around.
This is not to say that the bears’ argument is totally dead. (Livermore’s lengthy post goes much deeper.)
But the bottom line here is that the bears have been over-relying on a fundamentally flawed measure that has been exaggerating how far profit margins have come.