One of the key bearish arguments for why the stock market rally is bound to come to a nasty end rests on profit margins: They're at record highs and bound to come down, hitting corporate profits and making the stock market look expensive relative to earnings.
However, strategists at Goldman Sachs aren't siding with the bears on this one. Operating margins returned to a peak of 8.9 per cent at the end of 2013. But rather than fall, the strategists see margins hovering at about the current level throughout this year, nudging to a new record high of 9 per cent in 2015.
High margins, they argue, are part of a secular trend. Economic growth has been meagre in recent years and corporate revenues have shown only modest gains. That hasn't prevented margins from doubling over the past 30 years, "trending higher on the back of technological advances, cheaper and more productive labour, expansion to emerging markets, declining taxes and interest rates...."
Looking forward, the strategists believe, brings another pillar of support, in the form of economic acceleration and rising revenues, which should offset any margin erosion from rising labour costs.
This is a big deal for the bullish view on the stock market. After rising 180 per cent over the past five years, the S&P 500 trades at a relatively modest level of 17-times trailing earnings. Those skeptical of the rally have long argued, though, that this multiple is deceptive: As margins fall, the benchmark index will start looking expensive, until it falls too.
Goldman Sachs agrees that corporate earnings are highly sensitive to small changes in profit margins. By their calculations, each 50 basis points (or half a percentage point) shift in margins represents a $5 (U.S.) move in earnings per share for the S&P 500.
In other words, if margins rise to 9.4 per cent in 2014 – which is the more bullish consensus estimate – earnings will rise to $121 a share. If margins fall to 8.4 per cent, though, expect lower earnings of $111 a share.
For their part, Goldman Sachs is driving up the middle, predicting flat margins and a relatively lacklustre performance this year from the S&P 500. Equity strategist David Kostin has a 1,900 target for the benchmark index, implying an annual gain of just 2.8 per cent. The index is up 1.3 per cent so far.