Beware High Margins

by Addison Wiggin – April 4, 2011

  • Corporate America crowing about fat profit margins… Chris Mayer on why they may soon be eating crow… and a chart that shows stocks may be overpriced by 45%…
  • Silver at another post-1980 record… Eric Sprott on whether the white metal is due for a rest
  • A phone as powerful your old desktop computer… and the lucrative micro-sector that makes it possible
  • Vigilante reviewer on AMZN causes minor spat… while another reader has trouble wiping the grin off his face… and so much more… including digital editions of Dice

0:00 — With the Fed's self-fulfilling "wealth effect" taking hold…

both the Nasdaq and Russell 2000 indexes reaching heights above April 2008… and talk of QE2 ending before the June 30 deadline, we begin today's 5 with a question: What is the most likely pin to prick this 24-month bull?

"Profit margins," comes the plausible reply from Horizon Asset Management.

0:58"Profit margins are near peaks," writes Chris Mayer parsing the report into nuggets useful for our purposes. "Investors tend to like companies with fat profit margins, but high profit margins are like honey pots that attract competitors.

"They are rarely sustainable for long.

"What is more important for stock prices is not the profit margin itself, but the direction they move. Rising profit margins goose stock prices in wonderful ways, but declining profit margins are a tough anchor to overcome."

1:09The problem today is the most of the big blue chips report record profit margins. Let's look at the tech sector. Here are the profit margins of top 10 tech stocks on the Nasdaq-100, listed in order of market cap.

The top 10 techs in the market are sporting an average profit margin of nearly 26%. That number is "without any historical precedent whatsoever," Horizon notes.

"Profit margins are extremely high and unlikely to stay there," says Chris, "which ought to lead to earnings disappointments down the road — hence Cisco's one-day drop of 16% recently."

1:42The phenomenon extends well beyond techs. "There are quite a few companies," in the top 50 stocks in the S&P 500, Horizon's report says, "with very high absolute profit margins."

The nontech list is notable: Coca-Cola, Schlumberger, McDonald's, Occidental Petroleum and Freeport-McMoRan Copper & Gold "all have the common feature of after-tax net profit margins well in excess of 20%…

"In general, a 20% profit margin for any company is a historical rarity."

1:57"In some ways," Chris observes, "the surge in profit margins is what you would expect to see in the early phases of a recovery. Companies cut costs going in a downturn. Then, as sales rise, there is a big boost to the bottom line, as costs have yet to catch up.

"Today, though, I doubt many of these firms have much more to cut.

"Instead, the focus is now growing sales and taking business from competitors or defending an existing business. The focus, too, is how to deal with rising raw material costs. All of these put enormous pressure on margins.

"We should expect to see them fall."

2:24 — Ah yes, the "margin squeeze" we've been writing about since November. For which we have more evidence this morning: The ISM services index registered 59.7 in March — the 16th consecutive monthly increase. As with the better-known ISM manufacturing survey, 50 is the dividing line between expansion and contraction.

But the devil is in the details, and the "prices" component of the index came in at a screaming 72.1. We saw this last week in the manufacturing index too. Respondents to the services survey delivered anecdotal reports like these…

  • "Very concerned about high fuel costs"
  • "Freight costs going higher. Prices moving up"
  • "The increase in fuel costs has made both a direct and indirect impact."

Prices for all 37 commodities tracked by the index rose last month.

2:43"As an investor," Chris advises, "I think it is better to focus less on what profit margins are today and more on where they will go in the future.

"For the market overall, profit margins are likely headed south. Those that can maintain or increase their profit margins will be the exceptions. Finding them, though, could mean the difference between a winning investment and a losing one."

[Ed note: Chris closed out a winner yesterday for gains of 126%. For a sector where Chris has identified several companies that can overcome margin squeeze for even more impressive gains, check this out.]

3:08We expect "many companies will lower earnings guidance for 2011," adds Strategic Short Report editor Dan Amoss, once first-quarter earnings season gets under way next week. Stocks are flying high thanks to easy money from the Fed — the S&P is up 26% since Ben Bernanke signaled "QE2" in late August.

"The Fed's actions are temporarily pushing stock prices above intrinsic value, and when the Fed voluntarily moves (or is forced to by the bond market) to stop its money printing, stocks will quickly revisit their intrinsic values. Or, in other words, crash.

"The Shiller P/E of the S&P 500 is currently near 24 — about 45% higher than its long-term average:

"A move back to the long-term average valuation would take the S&P 500 back to 900. A move to bear market-low valuations would take the S&P 500 back to roughly 400."

As we write this morning, it's 1,332 — off 12 points from its mid-February high. "The Fed can't grow the intrinsic value of stocks," Dan concludes. "Only companies can do that, by earnings returns above their cost of capital."

3:49Gold sits on the high end of its range the last few days, the spot price currently $1,439. Silver is up a few more cents from yesterday's post-1980 high, at $38.65.

"I was suggesting when silver went through $24 that I thought it would get to $50 within a very short time, like four-six months," says Canadian hedge fund legend Eric Sprott. "We didn't quite make it, but the trend is there, and it's exhibiting all of the signs of going higher."

We agree. Mr. Sprott, by the way, will be joining us for the first time this year for the Agora Financial Investment Symposium in Vancouver, now that he's in partnership with crowd favorite Rick Rule. Early-registration discounts are still available. Call Barb Perriello at (800) 926-6575.

3:56The euro is backing off five-month highs against the dollar, after Moody's downgraded Portuguese government debt. It's still three notches above junk status, but the news was enough to pull the euro back to $1.418.

The dollar index is a hair below 76.

[Ed. note. We continue to offer a charter-member price for our newest service, Strategic Currency Trader, where readers last week bagged 153% and 170% gains in a mere four days. In by Monday, out by Friday — that's how it works in the market Abe Cofnas follows. Learn all about this one-of-a-kind service right here.

4:05"The power of the Internet is moving out of the home and office and into our pockets and purses," says Ray Blanco of our tech team, marveling at the new Motorola Atrix smartphone.

"In a package weighing a mere 135 grams, it sports dual 1-gigahertz ARM-based processors and a full gigabyte of fast DDR2 memory."

Don't sweat the jargon. Point is, "These specifications were enviable in a desktop computer setup weighing more than 50 pounds only a few years ago. Now it fits in your pocket."

But "the Atrix wouldn't be of much use if it could not communicate wirelessly. The real computer is the Internet. Without radio frequency circuits (RF), your mobile device would be little more than an expensive lump of plastic and silicon in your pocket."

RF is what makes Wi-Fi possible. And an advanced smartphone needs several advanced RF circuits. "The shift in how we compute represents an explosive growth investment opportunity for leaders in the RF space."

Ray is intrigued by one company that provides the whole package when it comes to an RF circuit — power amplification to reach a hot spot, and filtering to block extraneous RF signals that can cause interference. It's one more company Ray says will bring big money to early investors in a phenomenon he calls "Next Net."

4:40"The distance from Yemen to the Strait of Hormuz," a reader writes after seeing yesterday's issue, "is at least an hour flight on a jet. About as far as the distance from Libya to the middle of Italy.

"However, I guess that the map was a wrong one put there by mistake, as I am sure you know the geography better."

The 5: Nostra culpa. This is the correct one, which explains why Yemen is so strategic despite its relative lack of oil.

Byron places it all in context — how Yemen is a proxy in a wider war between Iran and Saudi Arabia, between Shia and Sunni Islam, and how it could double oil prices from current levels — right here.

5:00"Just watched the presentation of S.T.O.R.M.," a reader writes about the system editor Jonas Elmerraji uses in Penny Momentum Trader.

"Like the ideas! Just a question or two. I am a fairly new trader, but not a virgin. I am 58 years young and am working with a limited amount of dollars, $5,000. Can this system work for me?

"What are the share prices of the stocks, on average? I can't afford to buy 500 shares of a $10 per share stock. But I can afford to buy 500 shares of a $0.50/$1.00 per share stock.

"I work in a tough job that is taking its toll on my body. And don't think I can keep up with the physical demands for too many more years. Plus, like most folks, I would like to retire with something, because Social Security will not be there for me when I need it.

"I understand that you have devoted years to this research and model. And that you are in the business to make money also. I would appreciate a candid and honest answer."

The 5: "Share price is unimportant," Jonas replies. "Instead, the key to 'penny stock' behavior is market capitalization — when we talk about penny stocks, we're talking about small-cap stocks.

"Companies can manipulate their share prices by undertaking splits and secondary offerings that change the number of outstanding shares. They can't manipulate their market cap — that's why it's the metric we focus on to find small stocks.

"By that same token, you shouldn't worry about how many shares you can afford — instead, worry about what position size you can afford. Ultimately, making 10% on 500 shares of a $1 stock is exactly the same as making 10% on five shares of a $100 stock.

"Because S.T.O.R.M. uses technical analysis in determining our trades, risk is also defined from the get-go. In the case of the oil trade we put on yesterday, our downside risk is limited to around 4% of the position. But our upside target is around 20% right now (significantly more for the option). That sort of preset risk/reward makes deciding what you can afford much more simple."

Jonas recommends paper trading with the first few recommendations, just to get comfortable. Then you'll know soon enough the power of the S.T.O.R.M. system — generating gains this year like 10% in one week… 26% in three weeks… even 51% in five days. Jonas spells out the five elements behind his S.T.O.R.M. system right here.

Thanks to all of you, by the way, for making this possible on Amazon as of 5:15 p.m. EDT yesterday:

That said, it didn't happen without a little sturm und drang at Amazon.

Cheers,

Addison Wiggin
The 5 Min. Forecast

P.S. "As a long time subscriber to the Daily Reckoning," writes a self-appointed vigilante of the Amazon review process, "I'm blatantly appalled by the current promotional tactics being used to generate Amazon ratings and rankings…"

Yada Yada. Waah. "javajunki" then goes on to accuse us of trying to "game" the reviews. You may have seen his review on the site.

"On my word of honor," responded the first reviewer to post, which we shared with you yesterday, "Agora or Bill Bonner had absolutely nothing to do with it… I am mildly flattered that my review was used in subsequent advertising (actually you can't wipe the grin off my face with a Kerosene soaked rag)."

The spat took place shortly after we announced copies of Bill's new compendium of essays was available at Amazon, Laissez Faire Books and other locations.

But we suspect most interested readers hardly noticed. It's not without a little pride that we announce the book reached the No. 1 sales ranking in three categories last night: Economics, Investing and Accounting & Finance.

Work it.

P.P.S. "How about a digital edition?" another reader inquires further.

"Why does the digital version cost more than printed bound hardback?" asks another.

The 5: Digital editions are available at both Amazon and Barnes & Noble. And both of them sell for less than the hard-bound copy.

rspertzel

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