One of the primary reasons why I became bearish in early 2007 was due to the ever expanding operating margins of S&P 500 companies.  In 2007 operating margins were at an unsustainably high level of 8%.  While I never could have imagined what would unfold over the following two years I did know one thing was almost guaranteed to occur: margins would contract towards more historically sustainable levels and corporate profits would follow which would likely lead to lower or flat stock prices.

Currently, the operating margin of your average S&P 500 company is about 5%.  The gray lines in the chart below represent major market bottoms following recessions.  We’re currently well off the high, but not quite at the historical trough of 4% that we’ve seen during past major market bottoms.  I believe we have seen the majority of the margin contraction and could very well be nearing a trough, however, I would be more inclined to say that we will experience a 1975 type recovery rather than a 1991 type recovery.  There are just too many headwinds looking out at the next few years before we can see substantial margin expansion.

Cullen Roche

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