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The gloomy profits narrative underlying the economy and markets just isn't getting better

Sam Ro
Managing Editor

Last summer, it became very clear that the corporate earnings growth was coming to an end (Read here, here, here, and here). And what followed was months of volatile ups and downs in the markets.

Unfortunately, the earnings story hasn’t gotten much better during this period. And even worse, the long-term outlook for earnings growth seems to be deteriorating. This is all bad news considering earnings are the most important drivers of stock prices.

Corporate profits tanked

While the markets were closed on Friday, the Bureau of Economic Analysis released data showing that corporate profits had plunged 11.5% year-over-year during the fourth quarter of 2015. Excluding some unusual items, the decline was still an ugly 7.6%.

BEA via St. Louis Fed

Much of the drop can be blamed on the unfavorable effects low prices on the energy sector and the strong dollar on the export-driven manufacturing sector. However, economists warn of much broader concerns.

“[I]t also likely reflects the beginnings of a profit margin squeeze driven by tighter labor markets, rising wages, and weak productivity growth,” JPMorgan’s Jesse Edgerton said in an email.

The inflection in profit margins, which remain at elevated levels, is an unsettling change.

"The link between profit margins and recessions is strong," Barclays' Jonathan Glionna said in an October note to clients. In other words, the deterioration in margins we're witnessing has historically been an indicator of an impending economic recession.

Edgerton estimates there is a 26% probability that the US economy goes into recession within 12 months.

We haven’t seen this since the financial crisis

The story isn’t much different when you consider only the biggest publicly traded firms. According to FactSet, earnings for the S&P 500 (^GSPC) fell 3.6% during the Q4 of 2015. And that negative number is not a one-quarter deal.

“For Q1 2016, the estimated earnings decline is -8.7%,” FactSet’s John Butters said. “If the index reports a decline in earnings for Q1, it will mark the first time the index has seen four consecutive quarters of year-over-year declines in earnings since Q4 2008 through Q3 2009.”

While earnings aren’t crashing like they were during the crisis, they nevertheless aren’t exhibiting the type of growth that stock market investors would be excited about.

FactSet

And we should note that the earnings you are seeing here are benefiting from unusually favorable accounting adjustments.

The long-term story is depressing

For long-term investors, short-term gyrations in earnings and stock prices are to be expected.

The problem, however, is that the long-term outlook for earnings growth is uninspiring.

While it’s not never an easy task to forecast earnings, we can at least consider what’s implied by the markets. One way to do this is by first applying a premium over the return offered by the somewhat safer bond markets.

“When one applies a constant long-term equity risk premium of (academically-derived) 3.0% and incorporates both the 10-year bond yield and the dividend yield, one can calculate an embedded long-term EPS growth trend of less than 4%, which is below the implied levels seen since 1965,” Citi’s Tobias Levkovich observed in a February 12 note to clients.

Citi Research

It’s worth reiterating that this long-term outlook for earnings growth is derived from bond yields, which have been tumbling for the better part of the last three decades. But as Moody’s John Lonski argues, low bond yields are arguably an effect of low returns expected in riskier markets like the stock markets, which appear to be facing the prospect of low earnings growth.

“Expected returns from riskier assets help to determine US Treasury bond yields,” Lonski said in a March 17 note to clients. “All else the same, Treasury bond yields will be lower, the less is the expected return from other assets.”

In his note, titled “Long-Term Profits Outlook Lowest in Decades,” Lonski observed that the so-called “Blue Chip” consensus was currently forecasting a 3.2% average annual rate of profit growth for 2016 to 2022. This was down sharply from the 5.3% rate forecasted for the same period when the survey was conducted in March 2011.

This plays into the forecasts of money managers like Nuveen, GMO, and Hussman Funds, who have been calling for less-than-stellar returns in the stock market.

Perhaps all of this gloom is a good thing

In the near-term, the narratives of about earnings recessions, economic recessions, and heightened market volatility will probably continue.

But all told, perhaps all of this gloom may actually be an opportunity to buy, especially if what actually happens turns out to be better than what is currently expected to happen.

“While it is plausible that lower inflation and high margins are contributing to the mindset [of low long-term earnings growth], it seems challenging to believe that the long-term opportunity is that feeble,” Levkovich said.

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Sam Ro is managing editor at Yahoo Finance.

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