When Will Corporate Profit Margins Contract?

There are few signs of impending doom that are more widely cited than record high profit margins and the inevitable mean reversion that always comes following such an environment.  It’s true.  As you can see in the chart below profit margins have averaged about 6.5% over the last 65 years and every time they’ve gotten well above that 6.5% range they’ve come back to earth.


(Chart via Orcam Financial Group)

Now, I think there’s some validity to the idea that margins are structurally high (see here for details).  In other words, 6.5% isn’t necessarily a magnet sucking profit margins during contractions.  But I think it’s safe to say that 10.5% certainly isn’t the new normal either.

But this isn’t a question of if.  It’s a question of when.  Profit margins will mean revert at some point.  But they could also stay high for many years and you could miss huge gains like 2013 waiting for the mean reversion to actually occur.

One thing we know is that recessions are devastating for corporations.  And they’re not only devastating for corporations, they’re often devastating for markets.  In the last 60 years all of the year over year 30%+ declines in the S&P 500 have occurred inside of a recession.  In other words, outlier tail risk type returns tend to occur inside of a recession.  And if we look at profit margins we find something similar.  They almost always contract inside of a recession or within a few months of a recession.


(Chart via Orcam Financial Group)

So again, it comes down to being able to forecast a recession.   I hope your model works.


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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  • LVG

    I’ll just wait for the NBER to let me know when to sell. :-)

  • Effem

    Some of the reasons for structurally higher margins don’t hold up. For example: lower taxes = less money for the goverment to spend on goods or to give to consumers to spend on good. Therefore lower taxes only help if the government in turns borrows more to offset the lower revenue. Profits come down to consumer+ govt dis-saving…simple as that. Which makes the real question: will consumers and/or government ever pay down debt again?

  • Johnny Evers

    Taxes are neutral.
    If the government taxes less, then it will have less to spend, but the taxpayer will have more to spend.
    Taxes could be positive if the government takes money from somebody who is not using it and gives it to somebody who will. Or taxes could be helpful if government spends the money to grow the economy.
    Profits will only go up over the long-term if the economy expands. Profits have expand as they have over the past few years but I suspect this is mainly because of inflation in financial assets, because of overseas revenues and because profits are coming out of the net worth of labor. The latter is probably not sustainable.

  • PeterP

    You are assuming a balanced budget.

  • Tyler

    I realize this coming question is probably part of your bread and butter pay service, but do you have a couple indicators you favor to help judge is a recession is coming or underway?

  • Marcin

    Another reason I’ve thought off that could potentially be added to the list is accounting policy changes in the wake of the great recession. I’m not an expert in this field by any stretch, but would somebody knowledgeable chime in on this idea with any specifics? Personally, I’d imagine it could be things like mark to market rules, changes to amortization schedules, etc… am I on the right track here?

  • http://orcamgroup.com Cullen Roche

    I have constructed a fairly sophisticated model for predicting recessions that has a pretty good track record, but I am not selling access to it and I don’t post it publicly. Sorry.

  • http://highgreely.com John Daschbach

    What is the source of the corporate profit margin data? Is it market cap weighted?

    To me it makes little sense to consider corporate profit margins as a first order parameter. While all industries are subject to demand needs, different industries have very different structures for other input parameters. Exon and Apple have completely different input parameters and different sensitivities to them. Exon will never achieve the margins that Apple has enjoyed, but they are probably far more stable.

    I’ll send you a link when I’m done, but pretty much every stock market decline can be closely correlated in onset to either a jump in FFR (PRIME) or unemployment. The late 1990’s rise was punctuated by a jump in FFR, and a bump (but not spike) in unemployment. The market resumed moving upwards, the FFR came down a little, and unemployment after a flat period continued to decrease. But other than that, all large stock declines appear closely tied to some combination of FFR and UNRATE.

    All recessions lead to spikes in unemployment. Since they feed on each other it’s a vicious cycle. Certainly anything could happen, but it looks like the probability of a major recession is moderately low for now, so that makes the probability of a 30% stock decline not very high. One might be able to bootstrap the data enough to get distributions for a Markov Chain Monte Carlo to get some kind of statistical picture. My guess is a 10-15% decline in the next 2 years probably has a 50% or better chance, but the question is does it look like ca. 1995 or 2007?

  • Suvy

    Negative real interest rates are effectively a subsidy to corporations and almost all of the deficit has gone into corporate profits. So as long as negative real interest rates exist combined with the deficits we have, the current trends should continue to persist. I’m probably missing something here, but I don’t know what.

  • fin

    China and America might be different?

  • hangemhi

    not accessible anywhere to anyone?

  • Gary UK

    Governments only distort markets and waste money. Nothing else. A totally free market would solve 99% of the worlds troubles. Monopoly abuse is all that needs to be avoided.

  • Mike

    Profit margins will stay elevated until (and only if) there are increasing wage pressures due to labor tightness. This may happen as more boomers retire but it could be awhile.

  • Pod

    Rather than looking at aggregate corporate margins, it would be better to look at aggregate return on invested capital.

    This likely would not be easy given the accounting and limited aggregate data, but at a minimum one could look at a similar trend of invested-capital turnover, using the proxy,

    Sales /{corporate debt + equity market capitalization}

    Recall that ROIC = NOPAT margin * Capital Intensity

    I would be especially concerned if capital intensity were also above-normal never mind at historic highs. I suspect it is not.

  • Gary UK

    Just read Hussman, he gives it away for free, and he knows his stuff too.

  • kman

    Is there any way to guess how much of that margin xpansion might be due to smart stuff and automation ??


  • http://www.valueinvestingworld.com Joe

    Maybe one needs to forecast a recession, or maybe a rise in interest rates….either one a difficult or impossible thing to time. Leuthold Weeden comments on margins and how the rise is almost totally due to tax and interest rates (i.e. below the EBIT line):

    “The table is clear: the margin expansion story of the last 20 years is a financial one, not an operating one. Net profit margins have increased to 10.1% in the latest quarter from a technology-boom peak of 7.3% in the third quarter of 1997.

    But operating (or “EBIT”) margins have barely budged since that 1990’s peak—up only 20 basis points. The key developments have been the continuing shrinkage of interest expense and (secondarily) the corporate income tax burden; relative declines in these two items account for 2.6% of the 2.8% jump in net profit margins since 1997. Boring, but true. ”


  • Andrew P

    My guess is that the next recession won’t start in the US. We may not even see it coming. Things are very bubbly in Asia, but China is so opaque and inscrutable that it will be very hard for Americans to see the wave coming until it makes US landfall.

    Profits are coming out of the net worth of Labor (hence the political pressure to double the minimum wage), but with our luck Labor will win the wage fight just as the recession wave is coming over the pond.

  • indignado

    Corporations have been cutting costs, buying back stocks, and have faced very challenging top line growth environments these past few years. They have also taken on more debt at extremley low yields. Does anybody really think that profit margins are historically high because of consumers retrenching and a viable recovery is in place. The cart is being put before the horse here IMO.

    Margins are high now because corporations have stripped their operations down to a bare minimum. If we use a plane analogy it would go like this. The plane (corporations) have stripped down to a bare minimum (cost cutting) and are flying low on fuel over the middle fo the ocean waiting for the consumer (the refueler) to maintain thier strong forward guidance (the landing field).

    There is a lot of faith being put in the the consumer here. I think it is faith very misplaced. The strongest corporations and smaller businesses that have planned for such an occurence will survive a recession, but a lot of weaker companies that financed with historically low HYB rates will get crushed in a new recession. IMO

  • Suvy

    They are, but it still doesn’t change the fact that corporations get to borrow at negative real rates, right? Am I missing something?

  • chase

    “But I think it’s safe to say that 10.5% certainly isn’t the new normal either. But this isn’t a question of if. It’s a question of when. Profit margins will mean revert at some point.”

    Why? Will Coke’s margins depress? Or GE’s? Or Well Fargo’s? Or Union Pacific’s? Or IBM’s? Or McDonald’s? Comparing the market place of today (foreign earnings, lower taxes, more automation, more intellectual property…etc) to yesterday doesn’t seem to make a lot of sense.

    Not saying profit margins can’t fall because obviously they could for any number of reason…but I don’t think that it’s a forgone certainty they will just because we have 64 years of data…they could keep rising just as easily as they could fall.

  • Andrea Malagoli

    “One thing we know is that recessions are devastating for corporations.”

    I’d say recessions are even more devastating for employees, since they lose on the way down but they do not get it back on the way up. In this sense, recessions are a boon for corporations because they get these great excuses to cut employee benefits permanently. You can argue that recessions are a necessary tool for corporations to increase their margins. 2008 is the quintessential case. I do not buy into the technological innovation excuse. More simply, it is that employees have lost all their bargaining power for higher wages and benefits. If not, why would corporations keep cutting pension funds, medical benefits and wages when their margins are so high?

  • Kolenekeo C. Darwin Kaeo

    I would certainly like to peruse your economic indicators just, to align the accuracy of markets and how detailed. Sounds interesting.

  • http://highgreely.com John Daschbach

    Recessions are often not devastating for valued employees. I know quite a number of people (higher mid level $250K to $600 K) working for well known large cap firms who had to lay off many employees but ended up getting sizable bonuses, raises, and often promotions.

    The unemployment spike in every recession (that’s really what it is) provides a mechanism for companies to refine employment to the most productive workers.

    Is this the best for long term productivity? Certainly it is in the current situation where technological advances have made it possible to shed a large fraction of lower mid level workers.

    Your argument about technological advances seems odd. Almost all studies, and common sense, show that technological advances have dramatically reduced demand for lower-mid to mid level jobs. Workers in this group have lost bargaining power because of classic supply and demand.

    I think it’s wrong to bash companies over this. Things like health care, pensions, and even sustenance level basic employment should be our collective responsibility. We shouldn’t pass off on companies what is clearly the function of government.

  • Agon Kouros

    If the model exists in the forest, and no one can see it, does it exist? (Apologies to Bishop Berkeley.)

  • http://orcamgroup.com Cullen Roche

    It exists in my forest. Which I guess is more like one tree. :-)

  • Johnny Evers

    Most of America has never come out of the past recession … when you look at the employment participation, wages, and 401k/IRA balances for the median.
    But if the stock market goes down again, and the 10 percent with assets is hit, then we’ll hear lots of talk again about the weak economy.

  • scott

    You have to be kidding me. The next global recession will be here. There is no way printing money at such a logarithmic rate won’t bring the crows home to roost at some point. A paper is only as good as the tree it came from… we are sunk. A bizarre deflation/hyper inflation model is going to hit us so hard and fast no one will see it coming.

  • Asmodeus

    OUR Government also makes sure you’re safe in your home, make sure that consumers are protected from fraud and predatory business practices*, protect the environment* and ensure the safety of the food supply*.

    Corporations gouge for profits, destroy the economy for their own gain and ruin the environment. Are you sure you’re mad at the right people?

    *when corporations allow them to. Sadly we currently have more of a Fascism than a Democracy. Luckily for all the public, 2014 is here and we have a chance to change a few things.