Wednesday, August 22, 2018

Extended Expansion Sends Stocks to Record Highs Again

S&P 500 revenues and earnings soared to record highs during Q2-2018. No wonder the S&P 500 stock price index is back in record-high territory again. Let’s review the latest data before turning to the outlook for the fundamentals driving the stock market:

(1) Revenues at all-time high. Most extraordinary is that S&P 500 revenues jumped 10.3% y/y last quarter to a new record high (Fig. 1 and Fig. 2). Normally this far into an economic expansion, revenues growth tends to be around 4%-6%.

(2) Earnings at all-time high. S&P 500 earnings as measured by Thomson Reuters I/B/E/S soared 25.6% y/y last quarter, reflecting the strength in revenues as well as the cut in the corporate tax rate (Fig. 3 and Fig. 4).

(3) Profit margin at all-time high. Notwithstanding all the chatter about rising costs, the S&P 500 corporate profit margin rose once again to a record high of 10.9%. It was at a record 10.1% during Q4-2017 before the tax cut. It jumped to 10.5% during Q1-2018 thanks to the tax cut. Yet here it is at yet another record high. The bears have been growling during most of the current bull market that the margin is about to revert to the mean.

The bears have been warning all year that the flattening of the yield curve increases the risk of a recession. They’ve cautioned that the escalating trade war could trigger the expansion’s downfall. They’ve been expecting rising labor costs and commodity prices to squeeze profit margins. Nonetheless, they’ve been sounding the alarm that rising costs will boost inflation, which would send bond yields higher. They’ve touted the worrisome notion of “peak earnings,” which really means that the growth rate of earnings is bound to slow next year. And of course, the bull could drop dead at any time, they say, simply because it is so old. Consider the following counter-arguments:

(4) Leading higher. The yield curve is just one of the 10 components of the Index of Leading Economic Indicators, which has been setting fresh record highs for the past 17 months through July (Fig. 5).

That augurs well for the Index of Coincident Economic Indicators, which is also at a record high. This index’s y/y growth rate is highly correlated with the comparable growth rate for real GDP (Fig. 6). The former was 2.4% through July, confirming that the underlying growth of the economy continues to fluctuate between roughly 2%-3%, i.e., at a sustainable pace. The latest GDPNow estimate shows real GDP growing 4.3% (saar) during Q3. That translates into a 3.2% y/y growth rate.

(5) Trade war. President Trump unilaterally has called a ceasefire in his trade war with Europe. Progress reportedly is being made in negotiations with Mexico. Talks will resume with China later this month. Perhaps it’s time to stop using the adjective “escalating” to describe the trade war? What if all this leads to less protectionism once the fog of war clears? This possibility sure helps explain why the US stock market has performed so well so far this year!

(6) Inflation. It’s true that there are more signs of mounting inflationary pressures. They just aren’t bubbling up into the PPI, CPI, and wages. To have cost pressures rising even as profit margins likewise are rising without discernibly higher price inflation is a curious set of circumstances. Could it be that productivity is finally making a comeback? That certainly would explain things well. Also, the strong dollar is helping to keep a lid on inflation. Recently, commodity prices have been falling, not rising.

(7) Earnings. There’s no doubt that earnings growth will fall from over 20% this year to under 10% next year. So what? Earnings should still be growing in record-high territory in 2019. Stock prices should follow suit.

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