With the third quarter results season just about to get started in the US, the market will be focussed on the profits story in the coming weeks. Having rallied by over 7% already this year after an impressive nearly 30% price rise in 2013, there are some commentators who are worried that the market has risen too far too fast. But these worries ignore the fact that the starting point of the rally was a cheap valuation level and that underlying profits growth has been impressive. The key uncertainty is whether the corporate sector’s recent trend in profitability can continue or whether there is any sign of deterioration in the outlook. To assess this, we need to look in more detail at what has been driving profits.
There are two main ways of looking at profits growth – the stock market data, coming from company earnings releases which can then be aggregated to give a total market measure, and the macro-economic data that comes from national sources such as the Bureau of Economic Analysis. Over longer periods of time these different measures tend to give similar results, although significant divergences occur over shorter timescales which can cause confusion.
Data produced by S&P show that reported earnings were growing at an annual rate of 15% in Q1 this year. Operating profits from the same source appear to be growing at a rate of 11%. Current expectations are that profits growth will continue at the same rate – IBES data suggests a pace of around 11%, meaning that with sales growth of around 4%, the operating profit margin is expected to continue expanding. The second quarter data made a new operating margin record of just over 10%. This means that the listed US corporate sector has one of the highest operating profit margins in the world. In part this is due to the relatively high and rising weighting in the IT sector, although this is only part of the story. Every US sector apart from healthcare currently has a higher operating profit margin than the equivalent global average.
The economic data for profits in the US throw some light on what is going on at the total economy level. The long run data set shows that nominal profits have grown since 1950 at a 7% p.a. pace which compares with a 6% long run earnings per share growth rate for stock market profits – the difference being largely due to share issuance.
Digging further into the macro data shows that the domestic non-financial sector margin expansion has recently been driven by both the corporate sector’s ability to keep labour costs low and falling unit non labour costs. This cost control has meant that even with limited pricing power the domestic non-financial sector has experienced margin expansion at a time when sales volume growth has been average.
Overall then the corporate sector has achieved a very impressive result in recent years. Operating cash flow has been more than sufficient to cover investment requirements – so much so in fact that in aggregate the corporate sector has been buying back equity in the last few years, while also issuing more debt. Some commentators are worrying about the debt build up. On one hand, a modest increase in debt to take advantage of low interest rates is positive development since it ought to bring down the weighted average cost of capital, but too much debt can of course lead to problems in the future. We need to keep a close eye on balance sheet developments.
Another worry that keeps cropping up is that the quality of recent profits data has deteriorated, for three reasons. Firstly companies have benefited from lower interest rate charges on their debt, and it is hard to see how that can continue. It is more likely is that interest rates will eventually rise. Secondly the effective tax rate has come down in recent years and very recently has started to rise. And thirdly depreciation charges have been modest since 2009 reflecting the falls in capital expenditure post the credit crisis. These are also developments that we need to watch carefully.
Ultimately the key decision to make is straightforward – do we think that the rally in the stock market has gone too far based on the reported and likely future earnings per share delivery? As the chart below shows, the market started from a “cheap” level in 2012 using the 12 month prospective P/E. Recent price moves have taken the S&P500 to a valuation level that is slightly above average. From here, we need to worry more about fundamental developments than we did when valuation was unusually attractive. But all we can really hope to do is assess the current economic environment and the likelihood of the incentive structure changing in any way to hinder the opportunities for companies to continue to make money. We have to continue to remind ourselves that we cannot forecast profits and that a high profit share of GDP does not in itself imply a falling profit share in the period ahead!
We can, however, assess the risks to the profits outlook. With an operating profit margin already at high levels we need to be aware that there is a greater chance of it coming under pressure than rising further – risks could arise from the labour market, rising interest rates, a rising tax rate or higher depreciation charges as capex recovers. Several observers have been making this point for a couple of years now and have had to extend their time horizons as the corporate sector continues to deliver positive surprises – a sobering reminder of the follies of forecasting.
A neutrally-priced stock market where expectations are for further strong growth in earnings does present a challenge – overall we can expect to earn lower nominal returns from US equity than we have just had and we are watching very closely for any signs of deterioration in the fundamental story.