1Q Corporate Results Were Excellent, But Margins May Be Peaking

The dollar has also been a tailwind for sales: in the past year (thru 1Q18), the dollar depreciated by 6%; this accounts for about 3 percentage points of the growth in corporate sales. For the current quarter (2Q18), the dollar is pacing another 2-3% depreciation.

Why is this a tailwind? Companies in the S&P derive about half of their sales from outside of the US. When the dollar falls in value, the value of sales earned abroad (in foreign currency) rises, and vice versa. If foreign sales grow 5% but the dollar gains 5% against other currencies, then sales growth will be zero in dollar terms. The chart below compares changes in the dollar (blue line; inverted) with growth in S&P sales (red line): a lower dollar corresponds with higher sales (from Yardeni).

Earnings and Margins

Overall quarterly EPS (operating-basis) is now at a new high. It is 24% higher than a year ago on a quarterly-basis and 16% higher on a trailing 12-month basis (TTM).

The arrows again indicate the period where oil prices fell 70%. The new high in total EPS comes with energy sector EPS at half of its level in 2014.



Likewise, overall S&P profit margins peaked at 10.1% in early 2014, fell to 8% at the end of 2015 and have since rebounded to new highs of 11.6% in 1Q18.



For most sectors, margins remained relatively stable while energy fell and rebounded. In the past 5 quarters, non-energy margins have expanded from 9.9% to 10.9%.

Most of the largest sectors have done well, increasing their margins in the past 1 year and 2 years.

No sector has done better than technology, however, where margins have shot up from 15% to 22% in the past 2 years. This sector disproportionately benefits from a weaker dollar.




There are some common misconceptions that are regularly cited with respect to corporate earnings.

First, companies have been accused of inflating their financial reports through corporate buybacks. In reality, however, over 90% of the growth in earnings in the S&P over the past 8 years has come from better profits, not a reduction in shares. Better profits drive growth, not "financial engineering."



In fact, the impact of share reduction has declined over the past two years as the difference between EPS and profits has narrowed.



Second, equity prices are said to have far outpaced earnings during this bull market. In fact, better profits accounts for about 67% of the appreciation in the S&P over the past 8 years. Of course valuations have also risen - that is a feature of every bull market, as investors transition from pessimism to optimism - but this has been a smaller contributor. In comparison, 75% of the gain in the S&P between 1982-2000 was derived from a valuation increase (that data from Barry Ritholtz).

Over the past 2 years (since 1Q16), during which time the S&P has risen about 30%, earnings have risen faster than the S&P index itself, i.e., they have accounted for more than 100% of price appreciation. The same is true over the past 1 year.

Third, financial reports based on "operating earnings" are said to be fake. This complaint has been a feature of every bull market since at least the 1990s. In truth, the trend in GAAP earnings (red line) is the same as "operating earnings" (blue line).



It's accurate to say that operating earnings somewhat overstate and smooth profits compared earnings based on GAAP, but that is not new. In fact, the difference between operating and GAAP earnings in the past 25 years has been a median of 10% and the recent history has been no different (it was 9% in the most recent quarter). Operating earnings overstated profits by much more in the 1990s and earlier in the current bull market. The biggest differences have always been during bear markets.



Growth Outlook for 2018

Looking ahead, the consensus expects 19% earnings and 7% sales growth in 2018, falling to 9% earnings and 5% sales growth in 2019 (from FactSet). There are four considerations with a strong bearing on forward sales and earnings.

First, as a baseline, it is reasonable to assume that corporate (non-energy) sales growth will be largely similar to the nominal economic growth rate of 4-5%, excluding currency effects (from the OECD).



Second, the dollar has weakened over the past two years and is tracking a depreciation of 2-3% yoy for 2Q18. That means that currency effects are a tailwind to growth; with half of corporate sales coming from abroad, the weaker dollar could add another 1 percentage point to growth (second chart from JPM).




Third, the price of oil is tracking a healthy 35% yoy gain, meaning the energy sector should continue to be a tailwind to overall corporate sales and EPS growth.

As we have seen, the direct impact of oil prices on the energy sector is far more important than any ancillary affects on other sectors. As an example, consider this: the price of oil fell from over $100 to under $50 between mid-2013 and mid-2016 but non-energy sector operating margins were 10% in both instances.

Finally, the biggest wild card for 2018 is corporate tax cuts. Analysts estimate that these could add 7-10 percentage points to growth, meaning baseline growth of 4-5% could jump to 11-15%.

The tax cut is a one-off adjustment, applicable only to 2018, and there is not much reason to expect it to permanently raise growth rates. Why? US corporations are not capital constrained; they have abundant cash and access to low cost debt and equity. Moreover, corporations have been making fixed capital investments. Over the past 3 decades, rising corporate profitability (blue line) has had no positive affect on new investments (red line; from the FT).



Outlook for 2019: Peak Margins?

Next year, the consensus expects 9% earnings and 5% sales growth (from FactSet). This looks very unlikely.

The primary reason for skepticism is margins. For earnings to grow faster than sales, margins have to expand. But after trending higher over the past 7 years, margins expanded by 130bp in the past quarter. This is a massive jump and sustaining that level (let alone expanding margins further) is a very aggressive assumption, especially in face of (a) rising labor costs and (b) rising interest costs.




All else equal, an approximate guess would be that earnings in 2019 will grow no faster than sales (5%).


Valuation

Corporate growth should be a tailwind for equities in 2018 and perhaps in 2019 as well. With the correction in equities over the past 3 months, valuations are back to their 25-year average (from JPM).



Valuations are not cheap, but if investors once again become ebullient, there is room for valuations to expand. When investors become bullish (blue line), valuations rise (red line). Investors had been pessimistic in early 2016 and then became were very optimistic at the market peak in January 2018. That has been largely reset over the past 3 months, and further choppiness will likely make investors outright bearish (from Yardeni).



Valuations are influenced by more than investor psychology. Part of the reason equities have become more expensive over time is rising corporate profitability. Margins have reached successive new highs with each economic cycle over the past 3 decades: they are now more 100bp higher than in 2007, and that peak was more than 100bp higher than in 2000. Higher profitability (and growth) is typically rewarded with higher valuation multiples (from Yardeni).

Again, while it is objectively impossible to know when or at what level margins will peak for this cycle, it's a reasonable guess that significant further upside is probably limited.

Importantly, valuations have almost no bearing on the market's 1-year forward return (left side). But over the longer term, current valuations suggest that single digit annual returns are odds-on (right side; from JP Morgan).



In summary, corporate results in the first quarter were very good. S&P sales grew 10%, earnings rose 24% and profit margins expanded to a new all-time high of 11.6%.

Fundamentals are driving the stock market higher, not valuations: earnings during the past 1 year and 2 years have risen faster than the S&P index itself.

The outlook in 2018 looks solid right now: the consensus expects earnings to grow 19% this year. But, expectations for 9% earnings growth in 2019 will probably to be revised downwards; the substantial jump in margins this year is unlikely to be sustained, especially with labor and interest costs rising.

With the correction in equities over the past 3 months, valuations are back to their 25-year average. They are not cheap, but the excess from 2017 and early 2018 has been largely worked off.

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