One of the primary reasons why I became bearish in early 2007 was due to the ever expanding operating margins of S&P 500 companies. In 2007 operating margins were at an unsustainably high level of 8%. While I never could have imagined what would unfold over the following two years I did know one thing was almost guaranteed to occur: margins would contract towards more historically sustainable levels and corporate profits would follow which would likely lead to lower or flat stock prices.
Currently, the operating margin of your average S&P 500 company is about 5%. The gray lines in the chart below represent major market bottoms following recessions. We’re currently well off the high, but not quite at the historical trough of 4% that we’ve seen during past major market bottoms. I believe we have seen the majority of the margin contraction and could very well be nearing a trough, however, I would be more inclined to say that we will experience a 1975 type recovery rather than a 1991 type recovery. There are just too many headwinds looking out at the next few years before we can see substantial margin expansion.