One factor that has buoyed U.S. stocks in recent years is high profit margins. Corporate profits as percent of the country’s total output reached a record level of 10.8% in the first quarter of 2012, and they’ve gone even higher since then. In the third quarter of 2013 (the last period for which numbers are available) they reached a new record of 11%.
Part of the reason for record-high profitability may be the weak jobs market. Higher levels of unemployment since the financial crisis have resulted in less pressure on companies to increase their employees’ wages, leading to lower costs and higher profits.
Some analysts suggest that record-setting profitability is a bearish sign for the stock market going forward, since profits presumably have nowhere to go but down (the long-term average for corporate profits as a percent of the country’s total output is around 6.5%).
This decline may begin as the unemployment rate declines toward more normal levels (it’s now 6.7%, down from a high of 10% in late 2009). That would serve as a headwind for stocks, offsetting some of the benefit from stronger economic growth.
2013 was generally a good year for stocks, but emerging markets were a notable exception. While global stocks rose 20% during the year, including gains of around 30% in the United States, emerging markets posted negative returns. Whether emerging markets will rebound in 2014 will depend on a few key factors:
- Economic growth. There is generally only a weak link between economic growth rates and stock market returns, but the unexpectedly sharp declines in growth rates in 2013 for countries such as Brazil, China, India, and Mexico caused investors to rethink their assumptions about the future for these countries. A rebound in economic growth next year would help restore confidence in emerging market stocks.
- Political risk. 2013 was a popular year for protests, with political turmoil contributing to stock market declines in countries such as Brazil, Egypt, Thailand and Turkey. Emerging markets will be in the global spotlight again in 2014, with the Winter Olympics in Russia, the World Cup in Brazil, and national elections in countries such as Brazil and India. Whether political turbulence grabs the headlines during these events will help determine how risky investors view emerging markets to be.
- The outlook for developed economies. When it comes to stock markets, a rising tide tends to lift all boats, though not necessarily at the same speed. In 2013 an improving economic outlook for the US and Europe made emerging markets look less attractive in comparison. Further improvement in developed countries would likely have some positive effect on the growth rate of emerging economies, but it would also further erode the perception that emerging markets are the fast-growing alternative to stagnant developed markets.