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The greatest risk for your shares at the moment is hidden in plain sight

The US stock market faces a major threat from shrinking corporate profit margins.

They may not appreciate this threat. It’s easy to focus instead on the continued and surprising strength in economic demand, which has translated into a robust (double-digit) growth rate in corporate sales over the last year. But a seemingly modest decline in profit margins can turn strong sales growth into flat or even declining profits.

The SPX of the S&P 500,
+1.06%
Profit margin has declined over the past 12 months. For the second quarter of 2021, for example, that margin was 13.54% — an all-time high. For the second quarter of 2022, S&P Global estimates the margin is 10.87%.

So what’s the impact of this shrinking margin on stocks so far? The S&P 500 would be trading above 5,000 if its profit range hadn’t narrowed over the past year (all others remain constant). As you can see in the chart below, the current profit margin is still high by historical standards. For example, it’s 32% above its average since 1993. The stock market would crash if profit margins fell even halfway to that average.

But even if the S&P 500’s profit margin were to stay at its current high level, the market would struggle in the long run. With constant margin, future stock market growth can come from only two sources: revenue growth and/or P/E expansion.

None of these measures offer much reason for optimism. It’s hard to imagine how corporate earnings can grow faster than the overall economy over long periods of time. Over the next decade, real GDP is projected to grow at an annualized rate of 1.8%, according to the bipartisan Congressional Budget Office. Even that forecast could overstate the likely rate of growth in corporate revenue, given that S&P 500 revenues have grown at a slower pace than the broader economy over the past two decades.

The S&P 500’s current P/E ratio is already above its long-term average: It’s, for example, 8% above its 1970 average and 16% above its 1950 average.

marginal view

The prospect of a static S&P 500 profit margin for years to come is sobering enough. But unfortunately, margins are likely to come under downward pressure in the coming years, according to a report by two analysts at Ned Davis Research: Ed Clissold (Chief US Strategist) and Thanh Nguyen (Senior Quantitative Analyst).

One reason is that high inflation ravages profit margins. In a recent report to clients, Clissold and Nguyen pointed out that company profit margins were on a “pronounced downtrend from … the late 1960s to the peak of inflation in the early 1980s.” For example, in 1982 the margin was six percentage points lower than in 1966, for example. (This is according to a separate data series calculated by the Bureau of Economic Analysis, which includes more than just the S&P 500 companies.)

This reduced margin wasn’t caused by anemic sales growth. Between 1966 and 1983, according to Clissold and Nguyen, “Sales growth averaged 8.6% year over year… Inflation has severely squeezed profit margins.”

Of course, high inflation this time could prove short-lived. However, in another recent report, Clissold and Nguyen point out that low inflation could also squeeze profit margins in the near term: “For much of the world [coronavirus] During the pandemic, inflation has risen faster than wages, meaning companies have been able to pass higher costs on to customers overall. A counter-intuitive implication of the potential fall in inflation over the coming months is that inflation could fall below wage growth and put pressure on profit margins.”

Analysts therefore expect profit margins to come under pressure at least until the first half of 2023.

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 [email protected]

More: According to a Deutsche Bank survey, most investors expect the next big move for the S&P 500 will involve a nearly 20% drop

Plus: ‘Prepare for an epic finale’: Jeremy Grantham warns of ‘tragedy’ as ‘super-bubble’ could burst

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