Profit Margins Aren’t Just Higher in Tech. Call It a ‘Moneyball’ Rally.

A fan of the 2002 Oakland Athletics team holds up a sign declaring the team invincible during a game against the Kansas City Royals. (Jed Jacobsohn/Getty Images)

Key Points

• Third-quarter earnings season shows a strong start with many companies exceeding expectations and providing positive outlooks.
• S&P 500 net margins are near record highs, reaching 12.8% in the second quarter and likely for the third quarter.
• Seven of the S&P 500’s 11 sectors are more profitable than normal, indicating broad-based margin expansion beyond just technology.

Five tech titans report results this week, and between new stock market highs, optimism about trade, and a strong third-quarter earnings season, the bases are loaded. Some investors worry that with so much confidence in artificial intelligence, it is looking uncomfortably like Casey at the Bat.

Yet Moneyball may be a better analogy. Hiring solid but less spectacular players turned out to be a winner, to an extent, for the Oakland Athletics in 2002. And instead of relying on just a few megacap names, this rally has plenty of support from a broad base of less flashy industries.

Certainly, third-quarter earnings season hasn’t needed tech to get off to a much stronger-than-usual start. An unusually large share of companies are reporting better-than-expected top- and bottom-line results, while also sharing upbeat outlooks. It is strong profits, not just AI exuberance, that have fueled a good part of the market’s recent gains.

Moreover, expanding margins show that U.S. companies’ competitive advantages remain intact.

DataTrek Research co-founder Nicholas Colas notes that average net margins for S&P 500 components hit a peak of 13% in the second quarter of 2021. That makes sense because companies got a hand from the aggressively supportive monetary and fiscal policies rolled out in response to the wake of the Covid-19 pandemic.

Now, even though those positive factors are gone, net margins are back near record highs. They came in at 12.7% in the first quarter, 12.8% in the second quarter, and are likely to remain at 12.8% if earnings patterns hold for the third quarter.

That is evidence that fundamental factors are underpinning recent market highs.

Of course, a good deal of it is Big Tech, as those companies had an average net margin of 29% in the first half of the year, more than twice the index as a whole, Colas notes. However, he says that tech isn’t single-handedly carrying the load: Seven of the S&P 500’s 11 sectors are more profitable than normal.

“[T]his is an underappreciated positive for US large caps,” Colas writes. “It is not just Tech driving net margins higher; many other groups are also helping lift structural profit margins.”

In fact, financial companies’ third-quarter net margins are running at 19.9%, compared with their five-year average of 17.8%. Utilities’ margins are at 16.7% this quarter, compared with the 13.6% average. The same pattern holds for communications services, at 13.8% this quarter, versus 12.5% on average historically; industrials at 9.7% versus 9%; and consumer discretionary at 9.4% versus 7.6%. Consumer staples squeaked by at 6.5% versus 6.4%.

The upshot is that as long as margins go higher, valuations can too. That opens a path to further gains for a rally that many worry has run out of routes higher.

As Colas puts it, “if net margins can expand, then so can the market’s view of the appropriate value of U.S. large cap stocks.”

That means even if tech doesn’t hit a home run, investors can still score.

Write to Teresa Rivas at teresa.rivas@barrons.com