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Going Long

Profits Are Powering Stocks

The economy is nowhere near a cyclical peak, so earnings and stock prices still have room to rise.

When Standard & Poor’s 500-stock index hit an all-time high, some analysts immediately questioned how long the bull market could continue. In particular, they worried that even as the market climbed higher, corporate profits were headed for a fall.

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So far, the market’s rise seems to be on solid ground, based on 2013 earnings forecasts. S&P analysts see the benchmark index generating earnings of $111 per share. Based on the S&P’s April 5 close of 1553, the market’s price-earnings ratio is a reasonable 14. But market bears claim that corporate profits, measured either as a share of gross domestic product or against revenues, are unsustainably high. Since 1929, the earliest date for which GDP was calculated, the ratio of after-tax cor­porate profits to GDP has averaged 4.9%. In 2012, that ratio reached 6.9%. If profits were to fall back to their long-term average, earnings would decline by almost one-third and stocks would take a hit.

Income shift. But it’s important to note that corporate profits tell only part of the story. Over time, there’s been a shift from proprietors’ income—which measures profits from privately held firms, partnerships and other non-corporate businesses—to the corporate sector. Proprietors’ income, which has averaged 9.3% of GDP since 1929, is only 7.6% today.


That reflects a change in ownership that has taken place over the past 25 years. Recall that it wasn’t too long ago that almost all investment banks and brokerage firms were partnerships; before that, many banks and insurance com­panies were mutual companies, which were owned by their depositors and policyholders, not by shareholders. When you add together proprietors’ income and corporate profits, you get a number that’s equal to 14.4% of GDP—only slightly above the long-term average of 14.2%.

Comfortable margins. Stock market bears also believe that corporate profit margins—the ratio of profits to revenues—are unsustainably high. S&P reports that in the first three quarters of 2012, the profit margins of S&P 500 firms averaged 9.2%, compared with an average of 7.5% since 1994. If margins were to retreat to their historical levels, earnings would decline by 15% to 20%—again, bad news for stocks.

But today’s higher profit margins aren’t likely to decline. Increased foreign sales have contributed to rising margins because foreign corporate tax rates are well below those in the U.S. In fact, profit margins might expand even further if the U.S. lowers its corporate tax rate, now the second-highest combined rate among developed countries, edged out only by Japan.

Interestingly, nearly three-fourths of the overall increase in profit margins can be attributed to the technology sector. Firms such as Apple and Google have profited from their unique and innovative products and their market penetration. Also, tech firms have a high proportion of foreign sales, which, as noted, enjoy higher margins than in the U.S.


Nevertheless, tech stocks are now selling at an average P/E of 12, one of the lowest in years (see Opening Shot). That’s in sharp contrast to the stocks’ values at the 2000 market peak, when many large tech stocks had P/Es over 100, and it indicates that today’s investors are already anticipating some drop in profit margins.

When judging the potential for corporate profits to rise, it’s also important to realize that our current economy, with an unemployment rate over 7%, is nowhere near a cyclical peak. That tells me that earnings and stock prices still have room to rise. With interest rates at all-time lows, stocks continue to offer investors the best prospects.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania’s Wharton School and the author of Stocks for the Long Run and The Future for Investors.