Jefferies outlines the overlooked measure of corporate profitability that's pointing towards bigger stock gains ahead

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  • Jefferies says profit margins are indicating at least one extra quarter of improvement is ahead for stocks.
  • The “shock drop” in margins in the second quarter is rebounding just as quickly as the third quarter earnings did, the bank’s equity strategist said. 
  • He added that the lack of a blue wave election outcome and subsequent tax hikes will allow corporations to reinvest more, raising profits and pushing Jefferies to a “bullish outlook for 2H21.” 
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While many investors have focused on a sharp earnings rebound in the third quarter as a sign of a strong recovery, strategists from Jefferies see another signal that’s pointing to larger stock gains ahead.

A team of strategists led by Sean Darby said company profit margins are indicating that at at least one extra quarter of improvement is on the way.

“Just as earnings are cyclical, so too are margins,” Darby said in Friday note to clients. “Almost missed by market participants is the fact that the ‘shock’ drop in margins is reversing just as quickly. Glancing at the components of our margin proxy, there is probably at least a quarter of further margin improvement to go.” 

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82% of companies in the S&P 500 beat estimates in the third quarter, while 74% beat sales forecasts-a positive sign for profits, according to Jefferies. 

Darby added that the lack of a blue wave election outcome now signals that tax hikes will be less likely, so corporations will be able to reinvest more.

“The good news is that, as the corporate sector replenishes its inventories, capital investment intentions are rising,” he said. “While investors anticipated a large fiscal stimulus bill under a ‘Blue Wave’, the expectation of higher taxes might have quashed any investment or large capital outlays. This gives rise to Jefferies having a more bullish outlook for 2H21.”

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