By Mark Hulbert at Marketwatch
If profit margins revert to the norm, stocks could fall in unison
CHAPEL HILL, N.C. (MarketWatch) — Watch out if corporate-profit margins narrow to their long-term average share of gross domestic product. If so, the S&P 500 Index would trade at less than 1,700 in five years, a decline of more than 20%.
I’m not necessarily forecasting such a dismal eventuality, though it’s in the realm of possibility. I merely point it out to illustrate how dependent the stock market is on wide profit margins.
Few seem to be focusing on this vulnerability.
Take the discussion about George Mason University professor Tyler Cowen’s Friday column in The New York Times. Cowen discusses the possibility of a “Great Reset” as it collectively dawns on us that what workers in the future will earn a lot less than they did in the past. Yet I’ve not seen any mention in these discussions about Wall Street, where corporate profitability has been soaring even as wages struggle.
Wall Street needs to squarely face the possibility of a Great Reset of its own. If corporate-profit margins shrink even halfway to their long-term average, investors would suffer significant losses in coming years.
There is more than one way of calculating the average profit margin of corporate America, and each approach has defects. For the chart at the top of this column, I used a simple ratio of corporate-after-tax-profits to GDP, which shows the latest profit margin to be 8.7%. Though lower than 10.1% from a couple of years ago, the current level is still two standard deviations above the six-decade average of 6.3%.
To calculate what would happen if corporate profitability falls back to that average, I made a number of assumptions. For example, I assumed that this return to average takes five years. I also assumed that the S&P 500’s price-to-earnings ratio stays constant, which is a generous assumption since the market’s current P/E is 30% above its 130-year average.
I also had to assume a sales growth rate. I chose 4.2% annualized, which is how fast per-share sales for S&P 500 companies have grown since the economy emerged from the 2008-2009 recession. Notice that this generously assumes there will be no recession between now and May 2020.
Even with those assumptions, however, the S&P 500 SPX, -0.22% in May 2020 would be trading at 1,683 if corporate-profit margins revert to their historical average.
It’s also worth pointing out that the market faces an anemic future even if profit margins stay at their current lofty level. In that event, and assuming average P/E ratios in the future are no higher than they are today, the S&P 500’s future return will be close to the growth rate of their sales. If so, then the stock market faces many years of low single-digit growth.
In fact, other than P/E expansion, the only way I can see how the S&P 500 can grow at anywhere close to its historical average rate of about 10% annually is for the corporate-profit margin to widen even further. Robert Arnott, founder and chairman of Research Affiliates, argues that this is unlikely, since it would likely entail a further shrinking of the already reduced share of GDP going to worker compensation. In that event, he told me, “the backlash would be so widespread that it could turn Occupy Wall Street into a mainstream event.”
The bottom line? The stock market faces listless returns even if corporate-profit margins remain at their current much-higher-than-average levels. And if those margins do retreat, watch out!