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Apr 16, 2011

Investors Take Caution: The Market's Next Hurdle

By Andrew Mickey, Q1 Publishing

The market has resumed its uptrend. The Dow is up more than eight percent in the last month.

Nothing appears to be a problem for this market. The end of QE2, just two months away, isn’t a “serious” concern. Nor was a massive earthquake halting the world’s third largest economy. $100-plus oil hasn’t done much either. Even last month’s average unemployment numbers were received positively.

It’s enough to make a contrarian investor very, very worried. But there is one more hurdle that will stop this rally in its tracks and kick off the next correction or keep the buying frenzy going strong.

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The Next Hurdle

The next big hurdle for the markets is earnings.

For decades, the financial world has gotten together and let the company’s reveal their sales, costs, and net earnings for the world every few months.

The paradox of earnings season is that the more investors become confident, the greater the risks.

And the trend emerging over the last few years (and which has only grown more intense since the credit crunch) has created a lot of confidence.

A consistently shocking number of companies beat Wall Street’s highly paid army of analysts over the past two years:


As you can see, the largest companies (most often with the most complex financials) have been able to consistently beat expectations.

We often say great expectations tend to lead to great disappointments when in the stock market.

Over the last few years executives, Wall Street analysts, and investors have all learned that too. And they’re making sure it works for them.

We, however, will be looking beneath the headline numbers in order to get a true gauge of the health of the markets and where stocks are likely to go once all the “positive surprises” of earnings season are past and reality sets in again.

The Margins Don’t Lie

Although net earnings are easily massaged to meet or beat the estimates, there are a few numbers which don’t lie in the earnings reports. And they will help tip us off to whether a correction is nearing or whether we’re looking at another rally coming.

One of those numbers we always focus on is margins. They are numbers which truly don’t lie.

If a company is making doing more with less (i.e. making more sales without spending too much in discounts, hiring, etc. to do it), is able to pass on its increasing costs to customers, and having increasing pricing power resulting from rising demand for its products and services, it will show up in the margins.

Right now, all looks well in the margins. As Vitaliy Katsenelson at www.activevalueinvesting.com points out in the chart below, U.S. corporate profit margins are near an all-time high:


The margins in this case are showing stocks are exceptionally healthy which in itself is another cause for concern.

Remember, markets forecast current trends to last indefinitely into the future. The trends never last though.

As a result, we now have a clear set-up we’ve been through many times before.

The Lessons of History

Profit margins at these levels are clearly unsustainable. They’re actually a very bad omen for stocks over the medium term.

Jeremy Grantham of Grantham, Mayo, Van Otterloo, points out in only the way he can:

“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.”

We agree completely. As we saw at the height of the debt bubble in 2007 and our past research into when to buy and sell growth stocks, high margins don’t last forever.

The unsustainably high margins, just like most other market indicators, can and will last far longer than most investors normally expect.

This time probably won’t be any different.  

Right now, the coming inflationary storm is still in the early stages. Increasing costs of raw materials are easily passed onto customers.

Labor costs continue to stay low too as there are plenty of job seeks for every opening.

Borrowing costs too are very low too with the Fed artificially holding down short- and long-term interest rates.

In the end, these great times will not last forever. There will be a margin squeeze that will force a fundamental revaluation of stocks as much as 20% to 30% lower than they are today.

There are, however, opportunities where margins are still low and are catching up to the rest of the markets fast.

In a market like this where profit margins are unsustainably high and negative economic conditions are all written off as anomalies, you should taking an extra bit of caution. But as long as we’re looking where the herd has not already piled into and where margins have room to expand, we should be able to navigate the coming revaluation (whether it starts this summer or is still a year or two away) safely.

Early next week we’ll look at one industry poised for a big rebound in margins that’s actually benefitting from the housing bust.

Good investing,

 

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

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