22 April 2019

Threats To The Bull Market

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Revenue growth among S&P 500 Index (SPX) companies is experiencing a marked slowdown, and this has negative implications for the future trend of profits and stock prices, given that these companies also are under increasing pressure from rising costs. With 75% of the S&P 500 companies having reported 3Q 2018 earnings thus far, the latest U.S. Weekly Kickstart report from Goldman Sachs observes: "sales results have been disappointing, as only 29% of firms beat expectations, below the long-term average of 35%. The scarcity of sales beats has been reflected in stock returns." Given that U.S. GDP grew at a still-brisk annualized rate of 3.5% in 3Q 2018, the reduction in positive surprises, as detailed in the table below, is especially worrisome.       

Significance For Investors  

Companies reporting 3Q results so far have delivered, on average, a positive revenue surprise of 1%, equal to the figure for 2Q 2018, but half the 2% average surprise in 1Q 2018 and 4Q 2017, per Goldman. As the table below illustrates, year-over-year (YOY) sales growth for the S&P 500 as a whole is projected to decline by 40% from 2018 to 2019, with 5 industry sectors expected to endure even more dramatic decreases in their own sales growth rates that range from 50% to 100%.

"Tariffs, wage inflation, and rising interest rates pose three key risks to all-time high S&P 500 profit margins," the report leads off. On tariffs, Goldman says: "the actual impact of tariffs on 3Q results was minimal because implementation of the 10% levy on $200 billion of imports from China only started on Sept. 24. However, the tariff rate is slated to jump to 25% starting in January 2019 and an additional $267 billion of imports may be subjected to a 25% tariff."

Many businesses indicate that they are maintaining profit margins by passing along the cost of tariffs through price increases, Goldman says. Others are adjusting their supply chains, moving production away from China or switching to vendors in other countries. However, price increases inevitably will reduce demand, limiting the prospects for future sales growth.

Rising interest rates not only are adding to the funding costs of non-financial businesses, but also are dampening demand in key sectors, such as housing. As detailed in another Investopedia article, rising rates are dampening housing starts and new home sales, causing homebuilding and related stocks to plunge. The projected stalling of sales growth in the materials sector, as indicated in the table above, is partly the result of these negative developments in the housing market.

Rising wages represent a double-edged sword for business: they put pressure on profit margins, but they also raise demand, as long as wages are rising at a faster pace than consumer prices. However, as Goldman notes, an inevitable result of a tight labor market and rapidly rising wages is that companies are looking to boost productivity and possibly reduce headcount through measures such as increased automation.

Looking Ahead 

Given that sales revenues are a prime mover of profits and stock prices, the deceleration in sales growth has large negative implications. In this environment, generating earnings growth will depend increasingly on cost control, if not outright cost reduction, a considerably more difficult task for many businesses.

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