Our friends at Kailash Concepts recently opined on record high-profit margins. Kailash’s graph below shows that corporate profit margins, measured by total corporate profits as a percentage of economic activity, are at the highest levels in nearly 100 years. Kailash highlights that similar margins were seen in the run-up to the Great Depression. There are multiple reasons for the higher-than-normal profit margin. Before we get into some of them, consider that if companies are garnering a larger share of the economic spoils, then by default, individuals must get the short end of the stick. Hence, it’s not a coincidence that we have seen a spate of high-profile strikes and contract renegotiations.
The Kailash article notes three important contributors to outsized margins. Per Kailash Concepts:
Across numerous pieces of research, we have cautioned that these record margins were sourced from a combustible mix of leverage, falling interest rates, falling labor costs and that all three secular trends could be stalling or ending.
If interest rates are at a new higher plateau, as some suggest, corporations must either face profit pressures from high-interest expenses or pass said costs onto consumers. However, if interest rates are higher, inflation is likely higher. Under this circumstance, corporations will struggle to pass through rising materials and production costs and higher interest and labor expenses. The labor market is historically tight, with unemployment hovering at 50-year lows. If labor market dynamics do not revert to pre-pandemic norms, employees will continue to have leverage. Labor strikes will become even more commonplace.
What To Watch Today
Market Trading Update
Possibilities and probabilities are currently difficult to evaluate. The drubbing the market took this week is certainly disappointing. However, the market is approaching deep oversold conditions with some minor support heading into next week. Since March, whenever the market reached such oversold levels, a reflexive rally has ensued.
But there are many concerns weighing on sentiment currently. The Stocktrader Almanac summed up our current thinking well.
“What’s the history when turmoil grips the planet in October, heading into the Best Six Months of the year? Since WWII, there has been an ongoing war or international conflagration going on practically all the time. Things have come to a head in October many times, with several happening in the Mideast. Current events in the Middle East are especially tense.
We’ve tried to pinpoint the Recent High related to the crisis and then the nearest Subsequent Low around October. We included the nearest Crisis Low, the Q4, Year, Best Six Months, and Next Year % Changes.
We find ourselves today at a similar crossroads with the Hamas attack, Israel’s reaction and unrest in Mideast and on the world stage. If this situation can be contained the market will likely rally sharply. If it drags on or escalates that will likely negatively impact the market.”
We are still in the window of October weakness, but many seasonal factors should help support the markets.
Given the very negative levels of investor sentiment and oversold technical conditions, as shown, the possibility of a counter-trend rally is decent. Our weekly technical composite indicator has not been this oversold since October 2022 and is near levels that have historically always marked correction and bear market bottoms.
Investor sentiment is also extremely negative, which, when it reverses, provides the fuel for a rally.
However, use rallies into year-end to rebalance equity risk as needed.
The Week Ahead
In addition to earnings from some of the largest companies, the markets must also digest the Fed’s FOMC meeting on Wednesday and the BLS labor report on Friday.
Of interest on the earnings front will be Apple’s announcement on Thursday after the close. Given the volatility around the other mega-cap stocks’ earnings announcements this past week, we suspect Apple’s results may induce significant market gyrations.
The FOMC is expected to keep rates firm at 5.50%. We suspect Jerome Powell will provide more thoughts on how the recent increase in long-term rates affects Fed policy. While many Fed members are alluding to a pause, we see no reason for the Fed to back off of their higher for longer threat. The odds of a hike at the December 13th meeting have fallen from nearly 40% to 17%. The market appears to be buying recent Fed commentary about higher long-term interest rates doing the Fed’s job for them.
Economists expect the BLS to report the economy added 172k jobs in October. Such would be more in line with recent trends. Temporary/part-time employment, wages, and hours worked will be closely followed as they tend to be good leading indicators for employment. The ADP and JOLTs job openings data on Wednesday will also be given a lot of scrutiny.
The Largest Market Cap Stocks Aren’t Pulling Their Weight
The graphs below, courtesy of Ned Davis Research, are an interesting way to show that valuation expansion has been the culprit behind the significant outperformance of the top market cap stocks. The bottom graph shows the largest companies comprise a higher percentage of the S&P 500 market cap. However, their earnings are not keeping up. Currently, the stocks listed below account for about 27.5% of the price of the S&P 500 but only 17.5% of the earnings. The recent rally that kicked off in October 2022, in which the largest cap stocks led the way, showed a remarkable 8% increase in their price contribution yet a negligible change in their earnings contribution. In the longer run, either the valuations of said stocks will decline or earnings will rise much faster than the remainder of the index.
The Fed’s preferred gauge of inflation, the PCE prices index, shows that prices continue to moderate but seem to be getting hung up a bit. The Core PCE index was +0.4%, and the year-over-year rate was 3.4%. Both were a tenth of a percent higher than expectations.
Also, within the report, personal income rose by 0.3%, yet personal spending rose by 0.7%. The first graph below shows that personal outlays (orange) are growing more than disposable personal income (blue). As a result, the black savings line is falling, and credit usage (third graph) is rising. The recent spate of strong personal consumption data, like retail sales, is not sustainable. Also, higher credit balances and interest rates are taking a bite out of consumption. As the second graph shows, personal interest payments, excluding mortgage payments, have risen significantly. The third graph below, courtesy of Hedgeye, shows credit card balances are rising sharply despite the surge in interest rates.
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