More Profit Margin Records

We were impressed last week by Standard & Poor’s release of S&P 500 revenues per share and earnings per share. The former was up 18.5% y/y, while the latter soared 88.4% y/y (Fig. 1 and Fig. 2). Both are likely to mark cyclical peaks in these growth rates for a while. However, both should continue to grow through 2023. Here are our projected growth rates for S&P 500 revenues and earnings during 2021 (18%, 47%), 2022 (3%, 5%), and 2023 (3%, 7%).

We can use the two series to calculate the profit margin of the S&P 500 (Fig. 3 and Fig. 4). Before the pandemic, the margin peaked at a then-record high of 12.5% during Q3-2018. President Donald Trump’s corporate tax cut was a big booster of the margin that year. As a result of the pandemic, the margin fell to 8.9% during Q2-2020, but that was well above the 2.4% low during the Great Financial Crisis (GFC). The margin has rebounded from last year’s low to a record-high 14.1% during Q2.

We can use the data from the National Income and Products Accounts (NIPA) to calculate profit margins as well. Corporate after-tax book profits divided by nominal GDP also jumped to a record high of 11.8% during Q2, up from 8.1% a year ago (Fig. 5). Why the divergence between this measure of the margin and the S&P 500 one? The two series have generally followed the same path, though they do diverge, as they did in the years between the GFC and the Great Virus Crisis.

We give much more weight to the S&P series than the NIPA one. That’s because NIPA profits includes both C and S corporations, as I discuss in my forthcoming book, In Praise of Profits (late September release date). The S&P 500 are C corporations along with 1.8 million similar corporations. There are 5.0 million S corporations. Their profits are included in the NIPA series, but they are pass-through businesses, i.e., they pay most of their profits as dividends to their limited number of shareholders. Since the start of the data during Q4-1994, S&P 500 aggregate reported pre-tax income has accounted for about 60% of NIPA’s corporate book pre-tax profits (Fig. 6).

As we observed last week, the rebound in the S&P 500 profit margin to a new record high is impressive given all the headline news about rising costs. This suggests that either companies are passing the costs through to their prices or they are boosting productivity significantly. A third possibility is that they are both raising their prices and boosting their productivity. This most likely explains what is happening currently. Another factor to consider is that the S&P 500 includes commodity producers that are seeing their profit margins widen along with commodity prices. Now consider the following related developments:

(1) Sectors. Sure enough, the biggest upswings in profit margins among the S&P 500 sectors have been Energy and Materials, reflecting soaring commodity prices (Fig. 7). The margin for Energy is up from -8.6% during Q2-2020 to 6.9% during Q2-2021. Over the same period, the margin for Materials is up from 8.6% to a record-high 14.9%. However, there were other sectors at record highs during Q2, including Communication Services (18.6), Financials (22.3), Health Care (11.7), and Information Technology (25.0).

(2) Pricing. We now have August data for the regional business surveys conducted by five of the regional Federal Reserve Banks. The average of the prices-paid indexes has soared from a low of -4.9 last year during April to a record high of 84.1 this May (Fig. 8). It has stabilized around that level through August.

Meanwhile, the average of the prices-received indexes has continued to soar through August to a new record high. The spread of the average of prices-paid indexes to the average of the prices-received indexes rose from a low of 2.0 last year during March to peak at 40.8 this May (Fig. 9). It fell to 24.2 during August, suggesting that many companies are passing on the price increases they are paying by increasing the prices they are receiving.

The apparent peaking of the average prices-paid index suggests that the CRB all commodities index and the CRB raw industrials spot price indexes may be starting to peak (Fig. 10). The same can be said for the price of crude oil (Fig. 11). If so, that might be attributable to a slowing of economic activity resulting from a combination of the latest wave of the pandemic around the world and parts shortages, which are also partly related to the pandemic.

(3) Labor costs. Notwithstanding the many stories about widespread labor shortages, most of the upward pressure on wages so far has been occurring in only two major industries, namely leisure & hospitality and transportation & warehousing. This can best be seen in the annualized three-month percent changes in average hourly earnings (AHEs) through July. The total index rose 4.9%, which isn’t particularly alarming, especially if productivity is making a comeback too.

Here are the results for the major industries from highest to lowest: leisure & hospitality (15.7%), transportation & warehousing (12.1), professional & business services (7.1), manufacturing (5.6), other services (5.2), retail trade (4.8), financial activities (4.8), wholesale trade (4.6), construction (4.2), utilities (3.7), education & health services (3.4), natural resources (3.1), and information services (-0.3).

(4) Wage-price spiral. The strength of the S&P 500 profit margin in the face of severe labor shortages suggests that companies are finding ways to increase the physical and mental productivity of their labor force.

Among the biggest risks to the stock market would be a wage-price spiral reminiscent of the Great Inflation of the 1970s. In this scenario, productivity growth would be insufficient to offset wage pressures, forcing companies to raise prices. The resulting wage-price spiral would force the Fed to raise interest rates sooner rather than later. This actually is the most plausible reason for the Fed to start tapering its bond purchases sooner rather than later, as then it could proceed with raising interest rates if necessary.

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