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January 2012 Chart of the Month - Predicting Profitability Plunges

January 13, 2012
Tobias Levkovich, Chief US Equity Strategist, Citi

Investors have been desperately worried about peak corporate margins for at least a year with S&P 500 profits having climbed sharply even with a less than robust economic recovery. A reluctance to hire more employees as well as outsourcing to lower cost alternatives have left management teams with lean and mean companies. Yet, the anxiety over the ability to maintain such lofty margins remains very much in place.

Intriguingly, S&P operating margins have not yet reached the highs witnessed in 2007, though they are higher ex-Financials. Investors remain deeply worried that another EPS collapse is likely. It should be noted that in the 1990-91 and 2000-01 recessions, S&P 500 profit margins slid 1.5% and 1.0% points, respectively, and thus something short of a meltdown as experienced in 2008-09 seems to be reflected in current index levels.

The S&P 500 appears to be assuming a full point of margin slippage already. Another severe US recession would be needed to crush margins, as more than 70% of index profits are estimated to be derived domestically. Spot commodity prices have dropped which should pressure profitability, but much of that looks to be priced in already.

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