Corporate profits

Tightening corporate earnings is the biggest risk to the stock market right now

The US stock market faces a major threat from shrinking corporate profit margins.

You cannot appreciate this threat. It’s easy to focus instead on the continued and surprising strength of economic demand, which has translated into a robust (double-digit) growth rate in business sales over the past year. But a seemingly modest decline in profit margins can turn strong sales growth into stable or even declining profits.

The SPX of the S&P 500,
-1.13%
the profit margin has decreased over the last 12 months. For the second quarter of 2021, for example, this margin was 13.54%, an all-time high. For the second quarter of 2022, the margin is 10.87%, according to estimates by S&P Global.

What is the impact of this lower margin on inventory so far? The S&P 500 would be trading above 5,000 had its profit margin not declined over the past year (everything else being constant). As you can see in the chart below, the current profit margin is still high by historical standards. It is 32% higher than the average since 1993, for example. The stock market would plunge if the profit margin slipped even halfway from this average.

Still, the long-term market would be in trouble even if the S&P 500 profit margin were to remain at its currently still high level. With a constant margin, future stock market growth can only come from two sources: revenue growth and/or P/E expansion.

None of these measures offer much cause for optimism. It is difficult to see how corporate revenues can grow over long periods faster than the overall economy. Over the next decade, according to projections by the nonpartisan Congressional Budget Office, real GDP is expected to grow at an annualized rate of 1.8%. Even this projection may exaggerate the likely growth rate of corporate sales, because over the past two decades, S&P 500 earnings have grown more slowly than the economy as a whole.

The current P/E ratio of the S&P 500 is already above its long-term average: for example, it is 8% above its average since 1970 and 16% above the average since 1950.

Marginal perspective

The prospect of a static S&P 500 profit margin in the coming years is sobering. But, unfortunately, margins are likely to come under downward pressure in the coming years, according to a report by two Ned Davis Research analysts: Ed Clissold (Chief US Strategist) and Thanh Nguyen (Senior Quantitative Analyst).

One reason is that high inflation takes its toll on profit margins. In a recent report to clients, Clissold and Nguyen pointed out that corporate profit margins were in a “steep downward trend from the late 1960s to the peak of inflation in the early 1980s.” The margin in 1982 was six percentage points lower than it was in 1966, for example. (This is according to a separate data series calculated by the Bureau of Economic Analysiswhich encompasses more than the S&P 500 companies.)

This reduced margin was not caused by anemic sales growth. Between 1966 and 1983, according to Clissold and Nguyen, “annual sales growth averaged 8.6%… Inflation clearly ate at margins.”

High inflation could prove short-lived this time around, of course. But, in another recent report, Clissold and Nguyen point out that low inflation could also squeeze short-term profit margins: [coronavirus] pandemic, inflation rose faster than wages, meaning that overall businesses were able to pass on higher costs to customers. A counter-intuitive consequence of the potential decline in inflation in the coming months is that the rate of inflation could fall below wage growth, putting downward pressure on profit margins.

At a minimum, therefore, analysts believe there will be downward pressure on profit margins until at least the first half of 2023.

Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be reached at [email protected]

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