The continuous growth of Corporate America’s profit margin may not be sustainable in the long run, which could have a negative impact on the stock market.
According to S&P Dow Jones Indices, the operating profit margin for the first quarter of 2024 for the S&P 500’s SPX was estimated to be 11.76%, based on the results from the almost finished earnings season. The margin for the trailing four quarters is 11.44%, which is higher compared to the margins for calendar 2023 and 2022.
The chart below illustrates the return of the profit margin to its longer-term trendline. This occurred after a dip and subsequent rebound that were linked to the economic shutdown and stimulus measures in response to Covid-19.
If the S&P 500 profit margin maintains its current trajectory, it is projected to surpass 12% by calendar 2024, which is significantly higher than the 30-year average of 8%. According to John Butters, FactSet Senior Vice President and Senior Earnings Analyst, analysts are estimating exactly that. According to his report, analysts predict that the S&P 500’s operating profit margin will be 12.2%, 12.6%, and 12.5% over the next three quarters.
Not many people realise the extent to which the stock market’s current high level relies on the expansion of profit margins. Imagine if the profit margin from 30 years ago was still applicable today. In that case, the S&P 500 would currently be trading at 2,395, assuming all other factors remained constant.
For quite some time, economists have been pondering the sustainability of the increasing profit margin. Over the past 30 years, there has been a noticeable decline in the share of gross domestic income going to labour. This decline has come at the expense of labour, as their share has fallen from around 46% to 43%. The chart below clearly shows a noticeable downward trend spanning three decades.
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.
There have been numerous portrayals of a rather bleak outlook for the stock market’s future, with predictions based on the potential decline if the profit margin returns to its historical average. However, there is no need to make assumptions about declining profit margins in order to come to realistic projections about the market’s future. A profit margin that remains stagnant and fails to increase signifies below-average returns in the future.
That’s because, without a boost in profit margins, future stock market returns can only be derived from two factors: an increase in P/E multiples and growth in corporate sales. Both sources paint a bleak picture for the potential of a robust bull market in the coming decade. The U.S. market’s P/E ratio based on next 12-month earnings is already at an exceptionally high level, surpassing the majority of monthly readings since 2000. Investors should consider themselves fortunate if the P/E ratio manages to maintain its current high level without experiencing a decline.
Sales growth, on the other hand, is expected to be weak. The rate of sales growth has typically been lower than that of the overall economy, and it is expected that economic growth will be slower compared to previous periods. Throughout the past seventy years, the S&P 500’s sales-per-share growth rate has consistently been 0.7 annualised percentage points lower than that of the U.S. GDP. Projections from the non-partisan Congressional Budget Office (CBO) indicate that the real GDP in the U.S. is expected to experience a 2.0% annualised growth rate until 2034.
Based on the CBO projections and assuming a constant P/E ratio, the S&P 500’s inflation-adjusted annualised return is expected to be only 1.3% over the next decade, if we are optimistic.
