The U.S. stock market faces a major threat from shrinking corporate profit margins.
You may not 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 of corporate sales over the last year. But a seemingly modest decline in profit margins can transform strong sales growth into flat or even declining earnings.
The S&P 500’s SPX,
What’s the impact of this shrinking margin on stocks so far? The S&P 500 would be trading above 5,000 if its profit margin had 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 were to slide even halfway back to that average.
Yet the market over the long term would struggle even if the S&P 500’s profit margin were to remain at its currently still-elevated level. With a constant margin, future stock market growth can come from just two sources: revenue growth and/or P/E expansion.
Neither of those measures holds out much reason for optimism. It’s hard to see how corporate revenues can grow over long periods faster than the overall economy. Over the next decade, according to projections from the non-partisan Congressional Budget Office, real GDP is projected to grow at an annualized rate of 1.8%. Even that projection may overstate the likely growth rate of corporate sales, since over the past two decades S&P 500 revenues have growth more slowly than the overall economy.
The S&P 500’s current P/E ratio is already higher than its long-term average: it is 8% higher than its average since 1970, for example, and 16% higher than the average since 1950.
The prospect of a static S&P 500 profit margin in coming years is sobering enough. But, unfortunately margins are likely to face downward pressure in coming years, according to a report from two analysts at Ned Davis Research: Ed Clissold (Chief U.S. Strategist) and Thanh Nguyen (Senior Quantitative Analyst).
One reason is that high inflation wreaks havoc with profit margins. In a recent report to clients, Clissold and Nguyen pointed out that corporate profit margins were in a “pronounced downtrend from… the late 1960s to the inflation peak in the early 1980s.” The margin in 1982 was six percentage points lower than where it stood in 1966, for example. (This is according to a separate data series calculated by the Bureau of Economic Analysis, which encompasses more than just the S&P 500 companies.)
This reduced margin wasn’t caused by anemic sales growth. Between 1966 and 1983, according to Clissold and Nguyen, “year/ year sales growth averaged 8.6%… Inflation clearly ate into margins.”
High inflation could prove to be short-lived this time around, of course. But, in another recent report, Clissold and Nguyen point out that low inflation could also squeeze profit margins over the short term: “For much of the [coronavirus] pandemic, inflation has been rising faster than wages, meaning that in aggregate companies have been able to pass higher costs to customers. A counterintuitive consequence of the potential decline in inflation in the coming months is that the inflation rate could fall below wage growth, putting downward pressure on profit margins.”
At a minimum, therefore, the analysts believe that there will be downward pressure on profit margins at least through the first half of 2023.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org