The S&P 500 Earnings Challenge
The S&P 500 is trading at a forward PE of 24.0, higher than any previous reading in the past 120 years apart from the Dotcom bubble.
Downside risk far exceeds upside potential, with earnings multiples likely to fall as projected growth disappoints, while earnings forecasts are also based on unrealistic margins.
Operating Margins
Operating margins climbed to a high of 13.6%, compared to the 10-year average of 9.8%. Not only is the forward earnings multiple at an extreme level but the earnings to which that multiple is applied are based on operating margins that are unlikely to last.
Corporations are taking advantage of supply shortages to increase margins. Apart from supply chain interruptions caused by the pandemic, demand has been boosted by massive government stimulus (brown below), lifting personal income (blue).
The result has been a sharp rise in retail sales (green below) but this is about to end as stimulus declines and personal income falls. Disposable personal income (blue) is likely to revert to its pre-pandemic trend, around $17 trillion annualized, while retail sales are expected to fall to $480 billion per month.
Not only are sales likely to fall but operating margins are expected to narrow as demand shrinks and supply chains recover.
Capital Inflows
Distortion in the stock market has been fueled by massive capital inflows from private investors.
Personal saving spiked upwards by more than $2.5 trillion since the start of the pandemic, the result of falling consumption coupled with rising disposable income from government stimulus.
Personal saving (pink above) is now falling as government transfers (blue) return to normal levels (figures shown are for June '21 and February '20 before the pandemic).
Conclusion
The engine driving stock prices higher is now running on empty. We expect earnings multiples to fall, causing a major correction in stock prices, when capital inflows fueled by government transfers come to an end.
We also expect earnings to fall when supply chains eventually recover and operating margins are squeezed.
Acknowledgements
- Reported earnings, forward estimates, and operating margins are from S&P Dow Jones Indices
- Mike Zaccardi: Equity inflows
Quote for the Week
No amount of sophistication is going to allay the fact that all your knowledge is about the past and all your decisions are about the future.
~ Ian Wilson, former GE Chairman
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Colin Twiggs is director of The Patient Investor Pty Ltd, an Authorised Representative (no. 1256439) of MoneySherpa Pty Limited which holds Australian Financial Services Licence No. 451289.
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