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Declining profit margins threaten the market: Portfolio manager

Lawrence Lewitinn
Lawrence Lewitinn

The markets may be in the midst of a rebound but one portfolio manager sees a worrying sign for stocks hiding in plain sight – right on corporate income statements.

Though the S&P 500 suffered a brief correction over the summer, the market index has soared over the past six years in large part due to growing earnings, said Chad Morganlander, portfolio manager at Stifel Nicolaus’ Washington Crossing Advisors.

“Earnings growth within the S&P 500 (^GSPC) is rocket fuel for stock market performance,” he said. “Earnings are roughly 90% correlated to market performance.”

Since the market bottom in March 2009, the S&P 500 has gained 182%. During that same time period, forward earnings of all the companies in the index have gone from $65.88 to $125.68.

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Meanwhile, because the S&P 500 has moved up faster than underlying earnings, the index’s price-to-earnings (P/E) multiple has gone from under 9 times in 2009 to above 17 times today.

According to Morganlander, earnings are now being threatened. He notes that net margins – earnings as a percent of revenues – for the S&P 500 has stayed between 9% and 10% since 2011, well above its 10-year average of 8.8%, based on data compiled by FactSet.

But profitability has begun to trend downward. This month, net margins are at roughly 9.7% compared to the start of year when they were at 10.1%

“That is going to have an effect on all aggregate earnings for the S&P 500,” warns Morganlander. “It means that you're going to see subpar market returns as S&P [500] earning struggle to get even higher highs. Net margins, we believe, will continue to revert back to its mean, which will have a downward pressure effect on actual profitability.”

Though he expects the S&P 500 to be up by the end of 2016, Morganlander anticipates relatively modest gains of 5% for the index and recommends that investors looking to put money in the market cautiously “move up the quality spectrum.”

 

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