New York: In the middle of what may be the worst quarter for company profits since 2016, there’s a common refrain: This is as bad as it will get.
The last few months are the trough, and one quarter doesn’t make a year.
Anyone trading on that view have been a winner. The S&P 500 is en route to its fourth straight monthly advance and sits less than 1 per cent from a record.
But if you’re a bull, you should be aware of a dissident group of forecasters who see clouds looming on the S&P 500 earnings horizon. Specifically, they’re asking how likely earnings are to bounce back should profit margins narrow.
“Why are we optimistic — because the Fed says we’re done?” wondered David Spika, president of GuideStone Capital Management, in an interview at Bloomberg’s New York headquarters. “Ultimately, we need earnings growth, we need economic growth. To me, it’s short-sighted.”
The S&P 500 was little changed in the holiday-shortened week through Thursday, leaving the benchmark perched 0.9 per cent away from records last seen in September. Technology stocks again did well, sending the Nasdaq 100 up 0.8 per cent to a new high. At this altitude, confirmation that earnings are healthy is of heightened importance.
One thing bulls don’t want to hear is Wall Street preaching that costs are about to start eating into the bottom line. At more than 10 per cent, net margins are around the highest they’ve been in at least three decades, providing a boon to the bull market. And while inflation pressures are few and far between, concerns over higher layouts for labour, oil and other raw materials are swirling.
Bridgewater Associates recently warned clients that the immense widening of margins over the last 20 years, which it says accounted for half of the developed world’s stock returns, could be at a turning point. Strategists at Goldman Sachs have warned about profitability coming under pressure, too. At Morgan Stanley, researchers are pointing to decelerating global survey data as a precursor to lower margins.
“We are not convinced that the first quarter will be the trough in profit margins,” Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management, wrote to clients this week. “To the contrary, the leading properties of the PMI data suggest that the recent global slowdown could reverberate for at least another three months.”
One week into earnings season, and companies are already bemoaning higher costs. J.B. Hunt Transport Services, Inc., sometimes viewed as a bellwether for the global economy, mentioned higher salaries as one reason for lower operating income. PPG Industries Inc. cited “cost inflation in raw materials, logistics and wages,” although the paint-maker is working to offset the pressures.
To be sure, even if the start of the year marked the peak in corporate profitability, history suggests it will take time to seep into stock prices. On average, profit margins top out four quarters before the market does, a 2015 study completed by Strategas Research Partners found. And it bears noting that warnings that profit margins were about to collapse were rampant when the paper was published four years ago.
Profits for S&P 500 companies are expected to have fallen 3.3 per cent in the three months that ended in March. Forecasts show earnings should be flat in the second quarter, up less than 2 per cent in the third, and then grow almost 9 per cent in the fourth.
Estimates that distant have a habit of coming down and some analysts are already saying to forget about that big of a fourth-quarter rebound. While Wall Street firms have already taken the knife to estimates for the first three quarters, they haven’t yet made adjustments to the fourth, according to Ned Davis Research.
“There appears to be some delaying of estimate cuts and/or expecting reacceleration in the second half of 2019,” Ed Clissold, the firm’s chief US strategist, wrote in an April 16 note to clients. “Regardless of the reason, Q4 2019 numbers will likely be revised downward.”
For GuideStone’s Spika, margin compression poses a big question.
“The expectation is for a pretty significant decline in margins — we’re a little surprised that the market isn’t starting to price that in,” he said. “The thing that’s odd is you’ve got stocks almost back at all-time highs, almost all based on the Fed pause. We’re looking at the expectation for an earnings recession — two consecutive quarters of down earnings — we’ve clearly got margin compression, and the market doesn’t seem to care.”