October 15, 2012 2:46 pm

US earnings season – at the margins

Corporate margins tell if the market is cheap or expensive

The world is a complex and contentious place, but one controversial question – whether the stock market is presently cheap or expensive – can be reduced to a single issue: corporate margins.

Consider the S&P 500. Margins on the index, having crashed during the crisis, have bounced around near historical highs since the middle of last year, according to S&P. They hit 9.3 per cent in the second quarter and are expected to be steady in the third. If margins can remain high, the market, at 14 times trailing earnings, is not overpriced.

Sales growth on the index has been heading down for a year an a half, however, and in the past growth and margins have not trended in different directions for long. Should this historical pattern reassert itself, expect pain. If sales grow by 5 per cent next year (accelerating from their current pace), and margins drop by a percentage point, earnings on the index will be about $94 per share, almost a fifth lower than currently expected.

Two sets of results are particularly worth watching in this context: IBM on Tuesday afternoon and Google on Thursday. IBM’s service-driven technology business is managed explicitly for profits rather than sales. Long-term contracts and a diverse business mix have led to metronomically regular margin improvements. In the second quarter, for example, operating profits grew 6 per cent despite falling sales. If IBM slows, lesser companies will bleed.

Google, despite entering several new businesses, is still a search advertising company and this is a cyclical business. The cycle has been kind recently, with torrid growth in advertising volumes offsetting softer prices. This has kept Google’s profitability steady, despite heavy spending. If Google’s third-quarter results show advertisers cutting back, expect similar scrimping to hit other businesses as well.

Email the Lex team in confidence at lex@ft.com

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