The refrain on the TV business networks barely changes from one market strategist to the next, or from CNBC to Bloomberg: Corporate profits are soaring and will keep waxing in double digits for years to come. So although it appears you’re paying a heck of a lot for a dollar of earnings today, those earnings are rising so fast that you’ll book big gains tomorrow. And profits will ascend even faster than sharply-increasing share prices, bringing valuations on a glide path from today’s lofty numbers to a normal range. Listen to the Wall Street crowd, and you’d think that stock markets are on the cusp of a miraculous golden age.
The optimists largely base their bold predictions on the fantastic profits posted in this year’s first quarter. For the three months ended March 31, earnings-per-share for the S&P 500 jumped 15% from Q1 of 2017, to a record $32.71. That surge represented a gigantic improvement over the extremely lackluster record of the last three-plus years. For twelve months ended December 31, 2017, S&P reported, GAAP profits reached just $110 per share, an increase of 3.8% over the previous high of $106 recorded in September of 2014. In other words, most of the S&P 500’s profits failed to beat inflation for more than three-plus years through the close of 2017.
So what’s changed, and can the good times keep rolling? According to Howard Silverblatt, S&P’s senior industry analyst and leading expert on earnings trends, the two principal factors drove the leap forward. First, a strengthening economy swelled revenues, and since sales rose faster than expenses, “operating leverage” brought an outsize rise in profits. Second, the Trump corporate tax cuts provided an even stronger impetus. Silverblatt point out that in 2017, the S&P 500 actually paid an average tax rate of 24.4%. A reasonable estimate is that the levy has dropped around 10%, to something like 22%. That reduction alone would lift after-tax profits by an impressive 3.2% annually.
Hence, it’s a fact that corporate tax reform has lifted profits to a durably higher plateau. But lower tax rates provide only a one-time boost. The same increase in sales will raise EPS by the same percentage as in the past, albeit from a higher starting point. The bull case predicts that reaching this higher baseline is just the beginning, and that profits will absolutely explode from the new baseline going forward.
Investors should be as skeptical of the bluebird forecasts as they are grateful for the tax cuts. According to S&P’s data, analysts are predicting that EPS for the 500 will surge from $32.71 in Q1 to $39.90 in Q4, a rise of over 21% in nine months, or 7% per quarter. That would lift total earnings for 2018 to $147.40, a rise of 34% over 2017.
But is it really likely that America’s big corporations can become vastly more profitable in 2018 than they were in 2017? The tax cuts help, but not stupendously. Last year, operating margins stood at 10.1%, more than a full point higher than the average since 2006. In Q1, margins jumped to an incredible 11.3%. Nothing close to that figure has been achieved in the past 12 years.
Let’s say S&P sales rise a robust 5%, beating inflation by 2 points. For profits to ascend 34%, operating margins would need to hit something like 14.3%. That’s more than one-third higher than the average in recent years; it’s unlikely anything approaching that number has been recorded in the past several decades.
By the way, even if the S&P price index remains exactly where it is today, at 2770, at year end, stocks will be far from cheap––even if earnings do leap the predicted 34% in 2018. In that scenario, the S&P’s price-to-earnings ratio would stand at 18.8%. If the S&P rises even 6% from here, the PE would exceed 20.
At the end of last year, profits were already extremely high by historical standards, even though they’d plateaued for a few years. And that’s the problem. To be sure, tax reform provided an extra boost. But already rich earnings can’t get incredibly richer. Sure, the economy is relatively strong, but even 5% GDP growth (including inflation) doesn’t translate into earnings growth six times that high. Wall Street’s rhetoric is unhinged from the economic fundamentals. But earnings are governed by such gravitational forces as profits as a share of the economy, and the tendency of competition to erode extremely high profits. And gravity is pointing in the opposite direction.