The S&P 500 is reaching new highs. What happens next?

Keep Perspective

It’s been a bumpy ride in the stock market but so far it has paid to stay invested. The total return of the S&P 500 from January 1, 2019 to November 4, 2019 is 24%.

The bumpiness has been caused by fear of an economic recession. There have been several recession scares in the past two years, the most severe of which was last December when the market declined 19% in just three months. The fear hasn’t materialized yet and the market recovered from the decline in the first four months of this year.

Many economic worries remain, especially with the trade wars, low capital investment by companies and a global slowdown in growth. So far, that has been countered by steady consumer spending supported by low unemployment and wage growth. Higher government spending at the federal, state and local level has also helped.

What happens next?

Interesting pattern lately

We watch earnings closely for signs of weakness or strength because the correlation between the S&P 500 price and corporate operating earnings is very high, at 0.89 since 2008. This is in-line with historic correlations and we believe that this strong relationship will continue.

Profit margins have steadily increased over the past forty years. Productivity gains, more efficient global supply chains, and lower interest rates have all contributed to this trend. Profit margin expansion hasn’t happened every single year but the trendline overall has been up.

A higher profit margin means that earnings have been growing faster than sales as companies have increased productivity. Looking at the past few years, the growth rate of earnings has generally been above revenue growth, but not this year.

In the chart below, it is easy to see the jump in earnings in 2018 from the corporate tax cut, which really fueled profit growth but had little effect on sales. This year, revenue growth has been stronger than earnings. This could be the effect of tariffs, an increase in operating costs including wages, or both.

What is interesting is the forecast for earnings growth in 2020. Profits begin increasing faster than sales again. Companies are getting their mojo back.

The best companies are incredibly resilient and adapt quickly to change. With this slowdown, not all companies have been impacted equally.

Digging into the Details

The 500 companies that make up the S&P 500 are classified into eleven different sectors. If we breakdown the revenue and earnings growth for each of the sectors over four quarters, we get a finer view of what is happening.

The table above is listed in order of market capitalization size in the S&P 500 Index, which is shown in the first column. The Consumer sectors together make up 17.3% of the index, ahead of Health Care and less than Technology. The last four columns show the difference between the forecasted earnings growth and the forecasted revenue growth, from the last half of 2019 to the first half of 2020.

There is margin improvement across 80% of the market cap of the index. Investors like to see profit numbers heading in the right direction, which is why we continue to expect the market to be positive.

We see the biggest risk to the forecast, and opportunity, is the escalation or resolution of the trade wars. The uncertainty around trade policy has caused companies to slowdown or suspend reinvestment in their businesses. If the trade uncertainty is resolved, they should start spending again.

Is the Optimism Already Priced In?

During inflection points in the market, valuations can be misleading. When coming from a low period of earnings, P/E ratios look high because earnings haven’t caught up yet with improving fundamentals. This is different from when P/E ratios are high due to over-optimism.

There is still plenty of skepticism that improving earnings are real in 2020, which makes us more comfortable that it will happen. There is always plenty to be concerned about. In the industry, we call it “climbing the wall of worry.”

We advise staying the course and keeping an eye on earnings. The ugly politics and rhetoric of a presidential election year will add to the uncertainty but we believe that companies will continue to adapt positively, as they have in the past.

At Archer Bay Capital, we help clients with their long term financial goals. Contact us to discuss stocks, earnings and our forecast in greater detail, or to schedule a consultation today.