Hidden Factor That Could Crash The Stock Market

Source: St.Louis Federal Reserve - By Mark Hulbert, MarketWatch.

Chances are good that the U.S. stock market will be a disappointment over the next five years.

Here’s why: Shrinking profit margins will almost surely cause stock investors pain. Even under optimistic assumptions, it’s hard to see how those lower margins will allow the stock market to produce annualized returns from until now 2020 higher than in the low single-digits. Under more realistic assumptions, the market will do much worse.

This depressing picture derives from an under-appreciated statistic imbedded in last week’s revision of fourth-quarter GDP. I say “under-appreciated” because most of Wall Street focused on the cheery headline number in the government’s report — an upward revision of GDP growth in the last three months of 2015 from 1.0% to 1.4%.

But the report also showed that corporate profit margins — profits as a percentage of GDP — experienced one of their largest quarterly declines in years. That percentage is now 2.2 percentage points lower than where it stood in the first quarter of 2012 (see the chart at the top of this column).

That may not seem like a big deal, but it is. For every 1% drop in profit margins, for instance, corporate sales have to grow 1% faster in order for companies merely to maintain their previous earnings per share.

But the true picture is worse. Notice from the above chart that profit margins are in a distinct downtrend that is likely to last a lot longer. Almost without exception over the last seven decades, a decline of the magnitude already experienced took margins below where we stand currently.

The accompanying table reports the stock market’s annualized return over the next five years under various profit margin scenarios. My calculations assume that corporate sales per share will continue to grow at the same rate they have since 2009 (3.9% annualized) and the S&P 500’s SPX, +0.05% price/earnings ratio remains constant.

If corporate profit margins…

• Stay where they are now 3.9%
• Decline to their historical average 1.7%
• Overshoot the average and fall to where they stood at the trough of past profit-margin decline -5.6%

Is it possible for the U.S. market to do better? Of course, but the odds are quite low. The three, and only three, ways for equities to beat the odds are:

1. P/E expansion:

If price/earnings ratios widen, of course, then the market can rise even in the face of declining profits. But the S&P 500’s current P/E ratio is already 46% higher than the average since 1871, according to data from Yale University’s Robert Shiller.

2. Accelerated growth in corporate sales:

If sales grow faster, needless to say, then a lower profit margin can still translate into decent earnings. But the accompanying projections assume that sales growth experienced since the bottom of the last recession will continue for at least five more years — which unrealistically assumes no recession between now and 2020.

3. Expanding profit margins:

Though it’s possible for profit margins to reverse their downtrend, it’s hard to see how. The two major factors cited for profit margin expansion earlier this decade were lower taxes and declining interest rates. I can’t imagine lower corporate rates emerging anytime soon from our paralyzed political system, and average interest rates over the last five years are almost surely going to be higher going forward.

The bottom line? Hold the champagne. Though the government’s upward revision of GDP growth looked positive on the surface, a deeper look at the data shows the stock market currently is on shaky ground.