The Stock Market Has a Problem That Apple Doesn't

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Stocks closed off their record high today, with the S&P 500 losing 0.4%. However, the narrower, price-weighted Dow Jones Industrial Average did achieve another record high with a 0.1%, respectively. Both crossed psychological levels intraday, 1,700 for the S&P 500 and 18,000 for the Dow, prompting a flurry of warnings that we are in the middle of a stock market bubble.

Some warnings are more legitimate and better-reasoned than others. Speaking at the Reuters Global Investment Outlook Summit on Monday, legendary activist investor Carl Icahn said he is "very cautious" on the stock market, adding that he could see a "big drop" due to the fact that corporate earnings have been goosed more by low borrowing costs than managerial excellence.

Back on September 19, Icahn made it clear just that he is acting on that concern, telling CNBC: "... we're up 30% and yet we have a huge hedge on... I think right now the market is giving you a false picture. I don't think a lot of companies are doing that well. They're taking advantage of low interest rates." The S&P 500 is up 5.1% since then.

Icahn may have a point, though: Low interest rates (and low tax rates) are goosing the bottom line of U.S. companies. That's fine, as far as it goes, but it suggests that "core" profitability isn't as impressive as it appears. To confirm this, I took a look at the last 12 months' EBIT margin for the 420 non-financial companies in the S&P 500; EBIT stands for earnings before interest and taxes, i.e., the company's profits prior to having paid interest and taxes. It turns out that more than 40% of the companies sport current EBIT margins that are lower than their median value over the past 10 years.

Furthermore, low interest rates aren't immutable -- at some point, they will increase, sending interest costs higher and putting pressure on profits. That isn't the end of the story, however: If margins fall, it does not mean stocks will automatically do the same. As Richard Bernstein, of asset allocation firm Richard Bernstein Advisors, noted in July, margins peaked in 1981 and 1982 and declined through the great 1980s bull market. "I don't think history supports the notion that margin compression equates to bear markets," he told Reuters.

Of course, none of this discussion applies to Carl Icahn's favorite idea: Apple . The maker of the iPhone and the iPad only issued its first $17 billion slug of debt in April and, given, the ultra-low rates it obtained, the interest payments are essentially a rounding error compared to its profits. In addition, assuming it keeps a cash cushion, Apple will not need to refinance its debt at maturity. Those profit margins are all-natural -- no performance-enhancement (financial) products used here. (As far for Apple's tax rate is concerned, that's a separate matter altogether. Those are definitely not all-natural.)

While rising interest rates could hurt profit margins -- and stocks along with them - Apple's margins are driven by the quality of its franchise and competition within its industry. The threat of competition is genuine, but at 11.9 times next 12 months' earnings-per-share estimate -- a 22% discount to the S&P 500's multiple -- I know which of Apple shares or the market look the safer bet right now.

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Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him on Twitter @longrunreturns. The Motley Fool recommends and owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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