Flying High

by Scott Wren, Senior Global Equity Strategist

Key takeaways

  • Operating margins for the S&P 500 Index typically rise as the economy moves from early-cycle into the mid-to-later stages of a cycle.
  • While closely watching for a change in trend, we look for the currently robust operating margin to hold steady in 2019.

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We are not in the early innings of this ball game. If you look at the economic and market cycle using the analogy of a baseball game, we are likely into the last third of the game. Maybe there are one or two outs in the seventh inning. But what that also means is there is still more baseball to be played. And those last few innings will likely be played out over the next 12 to 24 months. The game, thus far, has been long and hard-fought, but the home team is feeling good with the way they have played. Having a game plan and sticking to it has helped get us through the rough spots.

So we are in the later stages of this cycle. Has the S&P 500 seen its top? We don’t think so. But as we move through the later innings, investors need to be aware of things the market will be focused on. We have talked many times over the last 18 months about risks to the stock market such as errant Federal Reserve (Fed) monetary policy maneuvers and slowing global growth. Much of the equity volatility since the September record high in the S&P 500 can be attributed to concerns over those two risks. In the later stages of a cycle, it is quite common for there to be market concerns over Fed policy and when or if it will become a headwind for the market that will eventually tip the economy into recession.

Another common market concern in the later stages of a cycle is the level of corporate profit margins. They are typically quite high coming into the mid-to-later stages of a cycle, and that certainly is the case right now with the S&P 500 Index. Consider that coming out of a recession or meaningful economic slowdown, companies are lean and mean after shedding expenses and reducing staff in an attempt to maintain some level of profitability until the business environment improves. That strategy translates into increasing profit margins as the economy eventually picks back up and brighter skies prevail. During those early stages of recovery, companies want to see their margins continue to grow and they try to hold the line on increased expenses and adding staff until they are confident that the growth trend will continue.

But at some point, as the economy improves and revenues grow, expenses will need to go up. Those additional expenses usually come in the form of new employees, equipment, and/or facilities to meet the increased demand or, better yet, to expand operations. For the market as a whole, most strategists pay close attention to macro influences like input prices and wage gains and their effect on the S&P 500’s operating margin.

Operating margins can be defined as earnings produced by a firm’s primary business operations, excluding extraordinary income and expenses. For the S&P 500 Index, operating margin is simply operating earnings per share divided by revenue (sales) per share. The S&P 500’s operating income margin has mostly steadily climbed in this expansion and currently stands at a robust 12.3%.

While we expect this margin level to hold in 2019, given the later innings we believe this cycle is in, we are watching for indications of where this high- flying level of profitability might be going in coming quarters.