Look Out Below? (For Falling Profit Margins)

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The investment managers at GMO subscribe to the "reversion to the mean" theory: If things have historically gravitated to a certain number, then it's probable they will return to that number. For example, if the S&P 500's (INDEX: ^GSPC) historical average P/E ratio sits at 14 prior to 1999, then the current level of 16.3 will eventually fall back to 14. But the P/E ratio is not the only thing that can revert to the mean. Have you heard about the record-high profit margins?

Profit margins past
From 1926 to 1999, the average profit margin of the S&P 500 was 4.9%. The current profit margin is estimated between 7% and 10%, depending on the source. In fact, some say today's profit margins are at the highest level in 57 years! Why are profit margins topping out on the tail end of a recession?

Profit margins present
In a recession, companies can find higher profit margins in several ways. The first way is most obvious to the public: A firm can cut expenses like jobs and wages, finding ways to squeeze more profit out of fewer sales. Another way to higher profit margins is through achieving a lower income tax rate, often through writing off losses during the tough years. For example, in 2009 ExxonMobil (NYS: XOM) not only recorded no income tax in the U.S., but recorded a $46 million tax benefit. A final way for a corporation to boost profits is through cheaper debt. Because the Federal Reserve has cut interest rates, companies can borrow money more cheaply, just as a homeowner can get a mortgage more cheaply.

But these leave out the largest driver of the recent spike in corporate profits, argues GMO's James Montier, and the one most susceptible to falling flat.

Big ol' government
Montier states that government expenditures boosted corporate profit margins 7.6%. He adds: "The government deficit may stay high this year, due largely to it being an election year. However, it is almost unthinkable that it will remain at current levels over the course of the next few years." This will lead to a fall in profit margins (back to the average), and hurt stock returns.

Montier also points out "Wall Street analysts expect profit margins to rise!" If your valuations of stocks are built on these analysts' models, then the price might be inflated. And even worse, from a McKinsey study, "On average, analysts' forecasts have been almost 100 percent too high." This means General Electric (NYS: GE) CEO Jeff Immelt, who believes his company can increase profit margins past its current 14.9%, will be fighting the mean reversion. This is also true for 3M (NYS: MMM) , which expects an operating margin between 21% and 22.5% this year over last year's 20.9%. However, a company like Yum! Brands (NYS: YUM) , which aims to make international sales 75% of revenue by 2015, may not be as affected by any change in government spending.

Or is it a new average?
Of course, Montier could be completely wrong, and there might have been a structural change resulting in sustained higher profit margins. It's possible that government spending, rarely a number to decline, will never fall much from its current high:

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It's also possible that profit margins revert only to a recent average over the past 10 years, instead of the historical average over the stock market's history, due to technological improvements and efficiencies that computers have brought.

Do you think profit margins will maintain their peak? Share your thoughts in the comments below.

If you think a lack of U.S. government spending will eventually throw a bear into this recent bull market, take a look at our free report that reveals three American stocks with a lessening dependence on their domestic business. Click here to read it; it's free!

At the time this article was published Fool contributor Dan Newman thinks changing names from Tricon to Yum! Brands was genius. He owns shares of ExxonMobil, but holds no shares of the other companies mentioned above. Follow him @TMFHelloNewman.Motley Fool newsletter services have recommended buying shares of 3M, ExxonMobil, and Yum! Brands. Motley Fool newsletter services have recommended creating a diagonal call position in 3M. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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