Can Corporate America continue to cut its way to profits?
If you're betting that stocks will rise in 2011, the answer is critical. Profits jumped last year largely because companies ran smarter and squeezed more from workers. Sales are picking up, but probably not enough to keep profits from rising fast in the new year unless companies can get even more out of their workers.
"How can they squeeze costs more than they are now?" asks Howard Silverblatt, a senior analyst at Standard & Poor's. "Are they going to fire more people? We're down to the skeleton."
Professional stock pickers aren't worried. They expect margins, or the profit made on each sale, will near a record this year. By the end of 2011, U.S. companies will be pocketing $9.50 in profit for every $100 in sales, or 9.5 percent, exceeding a boom-time record that is considered a bit of an aberration, according to Standard & Poor's.
The average over nearly three decades is $7.10. A clue as to whether the experts are right comes next week as companies begin reporting their fourth-quarter results. If investors begin to doubt those lofty margins are within reach, stocks could tumble. The Standard & Poor's 500 index rose 15 percent last year. Experts predict the index will rise another 11 percent in 2011.
The problem with margins is that they have already risen seven quarters in a row. The average margin is now 8.95 percent, nearly two percentage points higher than average.
Margins tend to stay around the historical average for two reasons.
When the economy is weak, companies cut workers and exploit technology to boost margins. But there's a limit to the number of people you can lay off and the software you can buy. When the economy strengthens and people start buying what you're selling, you have to hire more people to meet the demand and pay more to keep them. Margins drop fast, often back to the average.
In a report Friday, London analyst Andrew Smithers wrote investors are fooling themselves that stocks are a bargain with margins so high. He says margins are certain to suffer a large fall. It's a lonely view but it's shared by distinguished company. Jeremy Grantham, the legendary Boston money manager who predicted the housing crash, says margins are abnormal and set to drop.
These two have been saying this for most of the past year and could be proven wrong again. UBS economist Larry Hatheway says companies have learned to operate much more efficiently than in past decades. They use more workers in India and China to drive labor costs down and shop around more for cheaper raw materials and parts.
Then there is the elixir of a recovering economy. People are buying more cars, and they went on the biggest holiday shopping spree since 2006. What's more, the government reported Friday that the jobless rate fell to 9.4 percent from 9.8 percent, though the rate fell mostly because many people gave up looking for jobs.
As companies begin to report earnings this week, watch closely those that could find it difficult to pass higher costs to consumers. Morgan Stanley strategist Adam Parker, who has written extensively about margins, lists more than a dozen in a report last week, among them Arm & Hammer banking soda maker Church & Dwight Co. and steel maker Nucor Corp.
Tally Leger, a strategist at Barclays Capital, predicts stocks will climb 14 percent this year on rising margins, but even he is worried. He notes that if the optimists are wrong even a little, the impact on corporate fortunes could be great. Wall Street analysts see earnings for the S&P 500 hitting a record $95 a share. But if the margins they assume are off by a dollar, earnings will come in 10 percent lower. That would be a big blow to a stock market that already reflects high expectations.
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