PPI, CPI and Profit Margins

If you have been following the site for awhile you know that I frequently focus on profit margins. Currently, the profit margin on the S&P 500 index is 8.1%[1] versus a median level since 2000 of 6.5%. Corporate profits as measured by GDP[2] are 8.2% versus the long-term average level of 6.0%. As I have analyzed in the past, high corporate profit margins typically lead to below average profit growth in subsequent years. This is due profit margins being mean reverting. I would expect corporate profits growth to be below average going forward for this reason alone but another factor may contribute to this anticipated contraction in margins.

Producer and Consumer Price Index data – PPI and CPI respectively – was released last week. PPI came in at 4.1% year-over-year and CPI at 1.4%. Historically, the two measures of inflation have moved in tandem with the PPI index being more volatile and CPI more “sticky”. The chart below is the year-over-year change in each index since 1948.

You can see how much they move in unison and also that the PPI is more volatile. The historical correlation between the two indexes is .90.

I want to zoom in a little and take a look at the recent experience. Since early 2010 it appears that the PPI is trending up with the CPI in a down trend. While producer prices are rising they have not been able to pass these higher prices on to a still weak and de-leveraging consumer sector.

The current spread between PPI and CPI is 2.7% (4.1% – 1.4%). Since 1948, when the PPI-CPI spread is above 2.5% the corporate profit margin have compressed , on average, 12% over the next year. 

With corporate profits margins high and an unfavorable headwind in terms of input prices corporate margins appear ripe for a little mean reversion.

[1] As Reported Earnings ÷ Sales

[2] Corporate Profits After Tax ÷ GDP


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