“In the short run, the stock market is a voting machine, but in the long run, it is a weighing machine.”
Third quarter earnings season will kick off ominously on Friday, October 13 when several large banks report their results. After first and second quarter earnings far exceeded terribly low expectations, investors are hopeful that earnings have finally bottomed. In fact, analysts have become more cheerful about earnings for the second half of the year and 2024. Maybe too cheerful. If companies fail to beat increasing earnings expectations, that could disappoint investors and sink stocks — threatening this year’s rally.
Better than expected earnings results helped to propel stocks higher through the first seven months of the year. Despite an earnings recession — three consecutive quarters of negative year-over-year earnings growth — the percentage of companies surpassing their earnings forecasts was far greater than expected. And the magnitude of those beats was also higher than usual.
The primary reason that earnings were so much better than expected was that analysts’ first half forecasts anticipated an economic recession that, so far, hasn’t happened. Companies easily beat the dismal earnings predictions, raising investors’ hopes that a softish landing is still possible.
But if analysts’ earnings expectations were too low in the first half of the year, they may be too high now.
According to FactSet, calendar year 2023 earnings are expected to grow by 1.1%. That’s after both first and second quarter year-over-year earnings growth declined by 2% and 4.1%, respectively. Third quarter earnings growth is likely to be modestly positive, but analysts are forecasting that fourth quarter year-over-year earnings growth will increase by a staggering 8.3%. Calendar year 2024 forecasts for earnings growth are even rosier at 12.1%.1
In the short-term, the stock market is driven by sentiment — it’s a voting machine. Clearly, expectations for a first half economic recession were too pessimistic. And, when a recession didn’t surface, stocks rallied.
What about now? It’s equally clear that current analysts’ earnings forecasts for the remainder of this year and next predict a soft landing.
Perhaps this is too optimistic. Investors must ask themselves, if the economy hasn’t experienced an economic recession yet, how could earnings already have bottomed?
Investor sentiment is fickle. If companies fail to beat loftier future earnings expectations this quarter, faltering sentiment could send stocks reeling and put the market rally at risk.
So, what about the market’s prospects as a long-run weighing machine?
According to Empirical Research Partners, corporate margins nearly doubled from 7% in 2000 to more than 13% in early 2021, fueled by profitability in the technology and interactive media industries, falling interest and tax rates, and globalization that reduced labor costs and capital intensity of manufacturers. Today, the estimated third quarter net profit margin for S&P 500 companies is expected to be a still healthy 11.7%, which is above both the previous quarter’s net profit margin and the 5-year average.2
But is this extraordinary profit margin expansion repeatable?
Year-over-year earnings growth has been decreasing for three consecutive quarters. As a result, this year’s gains in the S&P 500 have been driven primarily by price-to-earnings multiple expansion — investors’ willingness to pay a greater price for each dollar of earnings. Historically, earnings have often increased by double-digit percentage rates following such multiple expansion. And, low and behold, that’s exactly what analysts are forecasting for next year’s earnings growth, 12.1%.3 But that contradicts today’s consensus view that profit margins have likely peaked as previous support has receded.
For example, over the past two decades, falling interest and tax rates accounted for the bulk of margin expansion, according to Empirical Research Partners. Declining interest rates added more than a percentage point to margin expansion since 2010. And if the 10-year Treasury yield remains at 4% or higher, it will reduce profit margins by at least half a percent over the next five years.4
Additionally, lower tax rates, especially after passage of the 2017 Tax Cuts and Jobs Act and increasing use of tax sheltering over the past 13 years boosted profit margins by more than a percentage point. The majority of multinational companies’ foreign earnings are often booked in tax-haven countries where tax rates are in the single digits. Current and projected massive US fiscal deficits make it unlikely that effective corporate tax rates will fall further. In fact, effective corporate tax rates for the technology sector, which have been among the lowest of the 11 economic sectors, have increased by about 3% since 2018.5
Globalization also helped to reduce labor costs and capital intensity for manufacturers. Empirical Research Partners suggests that even though manufacturing is only 12% of US GDP, it accounts for roughly 40% of earnings. The combination of lower labor costs, capital intensity, and advancements in technology such as robotics have bolstered profit margins by nearly a full percentage point since 2010.6 But, de-globalization and friendshoring could reverse all or part of that profit margin increase over the next several years.
Only advancements in technology remain bullish for the profit margin outlook. Since 2010, the technology and interactive media industries have accounted for the majority of the broader market’s profit margin gains; 8% margins have climbed to 23% while margins for the rest of the market increased from 6% to 9%.7 And tech’s leadership looks likely to continue.
It’s unlikely that the nearly doubling of profit margins so far this century will be repeated over the next decade. Higher interest costs, increasing effective corporate tax rates, and de-globalization are, at the very least, likely to temper profit margin expansion.
Short-term market volatility is often driven by shifts in investor sentiment. Although year-over-year earnings growth has declined for three consecutive quarters, investors have sent stocks soaring this year. All because earnings results for the first half of the year came in far better than feared.
Now, as the third quarter earnings season gets underway, investor sentiment has dramatically shifted. Analysts’ earnings estimates for the remainder of this year and next anticipate a softish economic landing. Pessimism has turned to optimism. And with this major shift in sentiment, the risk of disappointing investors and sinking stocks has increased.
Long-term investors often dismiss short-term changes in investor sentiment. After all, in the long run, cash flows, earnings, and dividends determine stock market performance. But there may be cause for concern here too as interest rates, corporate tax rates, and globalization move from profit margin tailwinds to headwinds.
These shifting market dynamics put the burden of sustaining profit margin expansion on Artificial Intelligence (AI). And while AI’s ability to boost corporate profitability remains uncertain, it could counteract some of the negative impacts to profit margins from higher interest rates, increasing taxes, and de-globalization.
Perhaps the best that investors can hope for is that profit margins remain at high levels. Even so, given that extraordinary profit margin expansion likely contributed to above average stock market performance, investors weighing the long-term profitability of companies may need to lower their expectations for future stock market gains.
We can view the market as a sentiment-driven voting machine or a fundamentals-driven weighing machine, but both are signaling potential trouble ahead.
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Friendshoring A growing trade practice where supply chain networks are focused on countries regarded as political and economic allies.
1 “Earnings Insight,” FactSet, September 29, 2023.
2 “Portfolio Strategy,” August 2023, Empirical Research Partners, August 1, 2023.
3 “Earnings Insight,” FactSet, September 29, 2023.
4 “Portfolio Strategy,” August 2023, Empirical Research Partners, August 1, 2023.
5 “Portfolio Strategy,” August 2023, Empirical Research Partners, August 1, 2023.
6 “Portfolio Strategy,” August 2023, Empirical Research Partners, August 1, 2023.
7 “Portfolio Strategy,” August 2023, Empirical Research Partners, August 1, 2023.
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