Uncategorized, Weekly Update

New Tax Law Causes Leap in Corporate Profit Margins

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Published July 6, 2018


Corporate earnings are driven by:

  1. increasing sales/revenues
  2. making more money per unit sold – aka increasing profit margins.

The recent change in tax law for corporations reduced the cost of doing business thereby increasing profit margins. Corporations can increase earnings PER SHARE by reducing the denominator – by reducing the number of shares outstanding. Fewer shares outstanding means more earnings per share. In recent years, corporations have been borrowing money at very low interest rates and using that money to buy back shares of their company stock, thus reducing the number of shares outstanding and making their earnings per share outstanding rise. The article below from Delta Investment blog brings these drivers of reported corporate profit together in a handy chart. Corporate earnings growth is fuel for stock price movement. The sharp rise in corporate earnings has underpinned the strong market performing in recent quarters. While the reduction in any cost, such as the change in tax law, creates a one-time jump in profit margin %, the dollar gains will stick around to support increased investment, or maybe an increase in share buybacks to further push corporate earnings per share higher. Herewith is Delta’s blog:

“At the end of 2017 the U.S. corporate tax rate was reduced to a flat 21 percent from a previous marginal rate that topped out at 35%. A significant share of corporate profits shifted from the Federal government to shareholders.

In the first quarter of 2018, S&P 500 profits increased by 26.8% year-over-year. The composition of this growth was:

1. margin expansion 16.6%
2. revenue growth 9.3%
3. share buybacks 0.8%

From 2001 through 2017, average S&P 500 earnings growth was 6.9% with the breakdown being 0.2% from stock buybacks, 3% from revenue growth and 3.8% from margin enhancement.

S&P 500 Y/Y EPS Growth Components

The jump in S&P 500 average margins from 3.8% to 16.6% is partly caused by the tax law change. As long as the current tax law remains in effect, the profitability boost will remain in effect. Second quarter earnings season begins in about one week. Consensus expectations for earnings growth in 2Q climbed from 19% to 20% last week.

In addition to the tax cut, margins benefited from significant revenue expansion. 1Q18 revenue growth of 9.3% versus the 2001-2017 average of 3.0% is impressive. It reflects fundamental strength and acceleration in economic growth.

It is important to recognize that the impact of the tax law is most obvious in the first year as the year-over-year comparisons (before tax cuts/after tax cuts). As time passes, the year-over-year growth rates will normalize but the absolute amount of profits being retained by shareholders is permanently increased.”

Market Update

Investors kicked off July on a positive note, with the S&P 500 rising +0.3%. Stocks were down as much as -0.7% early in the day on continued trade war rhetoric before reversing positively. That positive reversal was undone Tuesday as investors appeared nervous ahead of the July 4th holiday given the volatility of the trade tariff situation. A Chinese court ruling banning semiconductor firm Micron (MU) from selling chips in the country generated caution as well. Stocks ended down -0.5%. Positive feeling toward resolution of the trade issues sparked bulls Thursday. A +0.9% gain recouped much of the losses from earlier in the week. Friday brought a solid monthly employment report with modest wage gains keeping inflation concerns at bay. Stocks charged upward on the news adding +0.9% to close a positive holiday-shortened week.

The Thursday-Friday jump in stock prices left the S&P 500 (SPY) with a +1.53% gain, recovering the losses from the prior two weeks. The Nasdaq 100 (QQQ) climbed +2.31% while small cap stocks (IWM) lifted +3.86% to return to new high ground.

Warm wishes and until next week.