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.  Throw in the likelihood of higher prices due to the never ending printing presses and we could very well reach that 4% level before long.