Carl Icahn was recently reported saying that “Very simplistically put, a lot of the earnings are a mirage. They are not coming because the companies are well run but because of low interest rates.” He is suggesting that earnings are not driven by fundamentals but rather low borrowing costs and that poses a serious threat to the continued strength of the stock market. So is he right? The US central bank has kept rates at record lows since the credit crisis in an effort to stimulate borrowing and drive economic growth. One of the consequences of this policy is a flight by investors out of bonds and into risky assets and that explains why the S&P 500 and Dow Jones have both hit all-time highs this month. Many investors are saying these levels are supported by the strong earnings we have been seeing and even Janet Yellen, the nominated Fed Chair, mentioned that current asset risk premiums are warranted and that an asset bubble is not imminent.
If we look at monetary policy we can identify two ways in which it affects stock prices. It either improves conditions for corporations to strengthen and grow their earnings or it simply artificially inflates stock prices by offering low yields that we use to discount cash flows and arrive at current valuations. If we look at whether stocks are expensive or not at the moment, we can see that current forward P/E multiples are around 15 times annual earnings, in line with the 5-year average of 13 and the 10-year average of 14 (Figure 1).
Figure 1: S&P 500 P/E Multiples 2003-2013
This suggests that stocks are not expensive and earnings support current valuations but going back to Carl Icahn’s point, are these earnings sustainable and are businesses actually growing? In order to see where corporations stand in terms of profitability we can compare the long-term average corporate profit margin which is 5.9% to the current average profit margin which is near a record high of 9.3%. That’s a difference of 60% and analysts are expecting net margins to further increase and reach over 10% in 2014 according to FactSet. It is difficult to make the case that businesses will be able to continue feeding investors’ appetite for these high profits and a reversion towards more normal profitability levels will likely drive some investors to start selling. Given that unemployment continues to be high and inflation below the central bank’s target leads us to wonder how this near record high profitability is even possible. S&P 500 revenues are expected to grow by about 1% in the fourth quarter but earnings are expected to grow on average by over 10% and we can see in the chart below that revenues have grown less on average in the past 3 years when compared to earnings.
This is an indication that companies have been driving profits by cutting costs and buying back shares as opposed to selling more of their products and services. The continued high rate of unemployment suggests that companies are not hiring and with wages growing less than inflation, labour costs are being kept at a minimum. In addition, borrowing costs are at an all-time low and prices for raw materials used in production have been declining steadily since 2011. Businesses have also been sluggish in making significant capital investments as net business investment as a share of GDP is currently around 1.7% compared to pre-recession levels of over 3% and over 4.5% in 2000.
Looking on the bright side, consumer spending and personal disposable income are at an all-time high providing some support for the continued corporate earnings growth but also raising concerns about how sustainable these trends are. The US Fed provided guidance that it will start tapering its bond buying program in the near future, however that is conditional on unemployment declining another 0.8% and inflation rising to 2%. When this happens, borrowing costs will begin to rise, potentially leading consumers to borrow and spend less while investors will look towards less risky assets that will be offering more attractive yields. In addition, once these conditions are met we will see a lower unemployment rate which is indicative of higher demand for labour and consequently increasing wages while a higher inflation rate may mean that raw material prices will begin to rise. This will make it difficult for companies to maintain the current low costs of production and unless consumer demand increases significantly, we will likely see margins begin to shrink. All of these forces, coupled with the fact that revenue growth has been lagging when compared to earnings and considering that profit margins are 60% above their long-term average leads us to believe that corporate profits are likely to begin reverting towards lower, more appropriate levels in 2014, prompting markets to run out of fuel.
Tina Bazarca is a Research Associate for the Rotman Asset Management Association. She will be graduating from the MBA program at the Rotman School of Management in 2015. Tina can be reached at firstname.lastname@example.org
Financial Post. “Carl Icahn warns stock market could face ‘big drop;’ earnings a mirage”. http://business.financialpost.com/2013/11/19/carl-icahn-warns-stock-market-could-face-big-drop-earnings-a-mirage/.
Forbes. “S&P 500’s earnings growth is anemic and trending down”. http://www.forbes.com/sites/chuckjones/2013/09/30/sp-500s-earnings-growth-is-anemic-and-trending-down/
Trading Economics. http://www.tradingeconomics.com/united-states/indicators
The World Bank. “Commodity Markets” http://econ.worldbank.org