Commodities slip, margins rise: Welcome to fantasyland

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There?€™s a bullish train of thought in equity markets that chugs along something like this: Corporate profit margins had no problem sustaining historically high levels when costs for commodities were surging, so now that raw-material and fuel prices have eased, companies should

find it even easier to keep their margins high. Another reason to be confident in the outlook for corporate earnings, and ?€" by extension ?€" in the underlying health of the market. More related to this storyEU?€™s vicious-circle economics dooms it to failure Drop in Chinese inflation opens new can of worms Europe: Looking for the good news It?€™s an attractive and compelling argument. It?€™s also wrong. Commodity prices and profit margins do not typically head in opposite directions. The fact that they are doing so right now suggest that one of them is living in an unsustainable dreamland ?€" and unfortunately, it?€™s the profit margins.Follow the bouncing GDP?€œAs opposed to conventional thought, history shows that the direction of commodity prices tends to have a strong relationship with the trend of overall margins and earnings trends,?€ wrote Tobias Levkovich, chief U.S. equity strategist at Citigroup, in a research note this week.While this would seem to defy logic (don?€™t rising costs for materials and fuel cut into profits?), there?€™s a pretty obvious common thread uniting the two: Economic growth. In a healthy, booming economy, strong demand provides pricing power to both companies and commodities, fuelling profits for both.In the past few months, commodity prices have retreated ?€" in step with the decline of U.S. GDP growth and the general slowdown of the global economy. But U.S. profit margins haven?€™t played along. Why?Reading between the marginsCould margins in the United States have found some way to slip the surly bonds of GDP and remain high even in a slowdown? Maybe Corporate America?€™s steadfast resistance to hiring people in the recovery has paid off?Unlikely. Yes, the continuation of reduced payrolls could help soften the impact of a slowdown on profits, but if you believe declining demand won?€™t result in lower prices and weaker profits, you just failed Econ 101.More likely, what we are seeing is an inflection point in the profit cycle that isn?€™t yet reflected in those profit-margin statistics. Those margin numbers are based on financial results for the trailing 12 months; they still, in part, reflect conditions as much as a year ago. Commodity prices are much more forward-looking, as markets price in expectations for declining demand in the coming months.The profit margins need to play some catch-up with reality ?€" and almost certainly will do so in the next few months. That?€™s going to weigh on stock prices.?€œAccordingly, one has to worry that the equity market could face some problems in early 2012,?€ Mr. Levkovich wrote. Authors: Commodities - Yahoo! News Search Results

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