A strong case can be made that aggregate profit margins will not revert to 1990 levels. The composition of large US companies has shifted from traditional manufacturing to intellectual property–based companies with inherently higher margins and returns on capital, such as software, pharmaceuticals, and medical devices. In addition, these US-based companies derive a substantial share of their profits from outside the United States, which should allow them to sustain their size relative to other S&P 500 companies.

It’s less clear whether the current level of margins is sustainable. In the IT sector, for example, many of the current top companies (including Cisco, Google, Microsoft, Oracle, and Qualcomm) didn’t exist or were small in 1990—relative to both the size they are today and the size of the dominant companies in the market at that time. Given the dynamism of the sector, it’s impossible to say whether a next generation of competitors will take away some of the high profits of today’s top performers. Similarly, in pharmaceuticals and medical devices, today’s high margins are supported by blockbuster drugs that have been losing patent protection, opening the door to competition from generics. The sector’s R&D productivity has been declining over the past 20 years, and the next generation of drugs may have lower revenues and margins per drug as they are targeting smaller patient markets. Furthermore, US government steps to reduce healthcare costs could also affect margins in these industries.

?The current state of the financial sector is a conundrum. Despite increased regulation, the past four quarters combined have generated profits that are among the sector’s highest ever, on an annualized basis. In this era of ultralow interest rates, US banks have been earning near-record-high spreads between the rates at which they lend and the rates they pay on deposits and debt.5 It’s possible those spreads will decline to lower levels if interest rates increase to historical levels. Additionally, some sectors, such as transportation and manufacturing, are cyclical and at high points in their cycles.

Another, less tangible factor across all sectors is that companies may be underinvesting. For example, our recent survey found that a substantial number of executives believe their companies are passing up value-creating investment opportunities, especially in new-product and market development. If that continues, the current focus of many companies on cost cutting and short-term profits may well affect the sustainability of the market’s valuation.

Eoin Treacy's view

In the aftermath of the tech bust companies were faced with a Dollar that was falling in value against a wide basket of global currencies and a recessionary environment at home. Some of the more established companies have long had significant global operations but the attraction of expansion overseas was given a boost as capitalism was embraced by more countries and the global middle class expanded. 

The record pace with which margins have expanded is a testament to the success of corporations in managing their operations but the news will have to continue to improve in order for the expansion to continue. 

The US Dollar has been not been this low relative to emerging market currencies since the 1970s. If the sentiment of investors at the Contrary Opinion Forum is any guide, the view that currency’s recent strength, particularly against the Euro, is a signal that the secular bear market may be over. I agree this is likely over the medium-term but in the short-term there is ample opportunity for the Dollar to unwind its overbought condition.  

Taking a broader view, the potential for the Dollar to strengthen rather than weaken over time is a challenge for the consolidated earnings of major exporters not least as European and Chinese growth trajectories moderate. This may be yet be offset by a recovery in consumer demand in the USA but it would be dangerous to continue to extrapolate the trend in margins to ever higher levels when they are already elevated.