Where are Margins Headed?

The fourth quarter was another good one for stocks, with the S&P 500 returning 10.5%, and 32.4% for the year. This was the best calendar-year performance by the index since 1997. All four quarters of 2013 produced positive returns, with the first and fourth quarters, typically the strongest seasonally, both hitting double-digits. For the year Consumer Discretionary and Healthcare were the standout sectors, while Utilities and Telecom lagged. The laggards are not surprising, as they are income-oriented – an area of the market that was hurt by the backup in bond yields.

Ten-year Treasury yields rose 130 basis points (from about 1.7% to about 3%) during the year, and given the inverse relationship between price and yield, bond investors suffered. In fact, the Barclays Long-Term Treasury Index posted a return of negative 12.7%, which means that for the year stocks outperformed long-term Treasurys by about 45 percentage points. This of course is a monstrous gap, and what is truly unfortunate is that, as is often the case, it came after investors had fled stocks and flooded into bonds. What is remarkable is that, even after such divergent performance, stocks still look attractive relative to bonds, which speaks to the magnitude of the recent bond bubble.

The economy has been picking up a bit. Third quarter GDP grew 4.1%, though a good portion of this was from an inventory build-up. Unemployment claims and the unemployment rate have steadily declined, and payroll growth has improved. Consumer confidence and retail sales have also been strong. With the increase in bond yields (and mortgage rates) the housing market has cooled a bit. It will be interesting to see if the housing market can withstand a continued rise in longer-term interest rates.

In October Janet Yellen was nominated as the next chairman of the Federal Reserve Board, and in December the Fed announced that it will begin tapering its bond purchases in January. Though this tapering is earlier than consensus, and some would call it a tightening of monetary policy, it did not rattle the markets; in fact, stocks rallied in the aftermath. This rally may have been brought on by the Fed’s assurance that it will keep short-term rates low for an extended period.

Some believe this stock market rally is purely liquidity-driven and therefore must eventually reverse. We would certainly acknowledge that the Fed’s loose monetary policy has not hurt stocks, but we would also point out that valuations are reasonable and corporate capital allocation responsible. To us, the more compelling bear case is a potential decline in corporate profit margins, which are at historic highs. Let’s say net profit margins returned to more “normal” levels, by, say, falling from 9% to 6%. This may not sound like a big deal, but it would result in a hit to corporate earnings of one-third, assuming no change in revenue. If a company’s earnings fall by a third, and the stock’s P/E ratio stays the same, by definition the stock price declines by a third.

Nobody knows what the future holds, but for years the margin bears have been wrong, and the reason has to do with companies’ increased use of offshore labor and other manufacturing inputs, as well as robotics. The persistence of profitability has also been aided by the conservatism of managements; the less companies invest in growth, the easier it is to maintain the same profitability.

The greatest risks to margins are protectionism and aggressive managements, neither of which appears to be on the horizon. Furthermore, it is a very good sign that margins have maintained such a high level even though revenue growth has been mediocre. If the economy accelerates, and revenue growth picks up, margins might actually go higher. In sum, we understand the appeal of the margin bear case based on mean reversion and the natural tendency of managements to compete away profitability, but if we had to take a side – which we don’t necessarily have to – we would fade the margin skepticism.

On a related note, one of our favorite sectors currently is Financials. Among the reasons we like these stocks is that their profitability is depressed. While most of Corporate America is enjoying robust profit margins, the financial companies’ profitability has yet to fully recover from the financial crisis five years ago. This is due to lack of loan growth and low interest rates, both of which we believe are temporary. Our thinking is that when, or even before, conditions for the sector improve, the stocks should do well. The sector performed about in line with the S&P 500 in 2013 after a standout 2012, and we think it has further to run.

From a short-term standpoint, sentiment is a concern. Currently it is difficult to find people bearish on the market, and various measures point to high levels of bullishness. In addition, the ratio of stock purchases to sales for company insiders is unusually low. All of these point to the good possibility of a short-term correction, though this doesn’t affect our long-term positioning of portfolios.

Best regards,

Mark Oelschlager, CFA

Portfolio Manager

Oak Associates, ltd.

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