By Mark Hulbert
The danger to stocks from abnormally high profit margins
Corporate America's profit margin can't keep growing forever, and that has bearish implications for the stock market.
S&P Dow Jones Indices estimates that, based on results from the nearly complete first-quarter earnings season, the S&P 500's SPX operating profit margin for the first quarter of 2024 was 11.76%. The margin for the trailing four quarters is 11.44%, higher than for calendar 2023 and 2022.
As the chart below shows, these results represent a return of the profit margin to its longer-term trendline - after the dip and a rebound associated with the Covid-19 economic shutdown and economic stimulus.
If the S&P 500 profit margin continues to follow that trendline, for calendar 2024 it will be above 12% - well-above the 30-year average of 8%. That's precisely what analysts are estimating, according to John Butters, FactSet Senior Vice President and Senior Earnings Analyst. He reports that the analyst consensus is for the S&P 500's operating profit margin over the next three quarters to be 12.2%, 12.6% and 12.5%, respectively.
Few are aware of how much the stock market's current lofty level is dependent on the profit margin expanding. If the latest quarter's profit margin were the same as it was 30 years ago, holding everything else constant, the S&P 500 today would be trading at 2,395.
Economists have long wondered how much longer the profit margin can continue rising. Much of the increase over the decades has come at the expense of labor, whose share of gross domestic income has fallen over the past 30 years to 43% from around 46%. The distinct three-decade downtrend is clearly evident from the chart below.
Rob Arnott, founder and chairman of Research Affiliates, is one who believes profit margins are more likely to revert towards historical (lower) norms than rise indefinitely. In an email, he pointed out that while it's possible the several-decade uptrend can continue a while longer, it can turn down at any time.
You don't have to assume profit margins will fall in order to reach sobering projections about the market's future.
Many have painted very gloomy pictures of the stock market's future by calculating how much the stock market would fall if the profit margin reverts to its historical mean. But you don't have to assume profit margins will fall in order to reach sobering projections about the market's future. A profit margin that merely stops growing, and simply stays at current levels, translates to well-below-average returns in coming years.
That's because, without increasing profit margins, future stock market returns can only come from two sources: expanding P/E multiples and corporate sales growth. Neither provides much hope for a strong bull market over the next decade. The U.S. market's P/E ratio based on next 12-month earnings is already higher than 95% of all monthly readings since 2000, for example. So investors would be lucky if the P/E ratio remains at its currently lofty level and doesn't fall.
Sales growth, meanwhile, is likely to be anemic. Sales historically have grown more slowly than the economy as a whole and economic growth is likely to be slower than in the past. Over the past seven decades, for example, the S&P 500's sales-per-share growth rate was 0.7 annualized percentage points below that of U.S. GDP. According to projections from the non-partisan Congressional Budget Office (CBO), real GDP in the U.S. will grow at a 2.0% annualized rate between now and 2034.
If the CBO projections are accurate, and if we (optimistically) assume the P/E ratio remains constant, the S&P 500's inflation-adjusted annualized return will be just 1.3% over the next decade.
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 mark@hulbertratings.com
More: Stock-market investors fear a consumer slowdown. Keep an eye on gasoline demand.
Also read: If the economic outlook is so good, why are people tapping their 401(k)s?
-Mark Hulbert
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05-11-24 0812ET
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