Earnings Season Warning: It's Not Only Stock Market Valuations That Are Inflated!

Summary

• Monetary expansion helps inflate both stock market valuations and earnings.
• Inflated earnings dependent on an acceleration in the money supply growth rate is not however sustainable.
• Earnings will therefore be negatively affected when monetary inflation decelerates.
• Consequently, stock market valuations and earnings will both likely drop bringing about an even larger drop in stock market prices.

I discussed in a recent article a plausible reason why the bull market in stocks have lasted so long. (See A Plausible Reason For The Longevity Of The Bull Market In U.S. Stocks.) In essence, I argue low levels of investments have softened the business cycle and made possible a steady and significant expansion of the money supply combined with a prolonged period of historically low interest rates. These developments have been very positive for stock prices as the chart below indicates (which compares a broad U.S. stock market index with the money supply divided by corporate bond yields).

Stock prices benefit indirectly from an increased rate of monetary expansion since earnings will likely increase while discount rates will tend to decline, and directly as the demand for stocks tend to outpace supply. (I explain in detail how monetary inflation affects earnings, discount rates, and stock prices in Money Cycles - The Curse of an Elastic Money Supply.) Increased monetary inflation combined with lower interest rates also tend to make investors more bullish (and desperate for yield) which tend to channel yet more money into the stock market.

Since the financial results reported by companies are stated in monetary terms (price in US$ * quantity), the results are not only determined by the actual physical output sold and input used, but also on the purchasing power of the reporting currency. In a progressing economy - an economy where physical output increases over time - an inflating money supply allows prices to increase (or fall less than otherwise) in tandem with increased output. This would be impossible if the money supply were static as prices would then have to come down for the market to clear.

With the elastic currencies employed today, both revenues and costs stated in money terms will tend to increase with the money supply. (Note: an elastic currency is money which can change in quantity to satisfy changes in demand.) If profit margins remain largely unchanged or improve, earnings will also increase. Longer term correlations between the money supply and corporate sales and earnings (and also other economic aggregates measured in monetary terms) tend to be a close one as a consequence. (See, for example, Economic Growth Is Not GDP Growth or the Money Cycles piece, linked above.) The ever-expanding quantity of money is hence a primary reason why aggregate corporate sales and earnings have historically increased with time. In short, aggregate company earnings are over the longer term restricted by the money supply and not the physical quantity of goods and services produced and sold.

When monetary inflation accelerates over a period of time, company profit margins tend to widen. Since this inflation tends to push most prices higher, the time lag between the recognition of expenditures and sales inevitably means that costs at the time sales occur do not fully reflect the price inflation that has taken place in the interim. This timing mismatch drives profit margins higher than they otherwise would have been. Realised and unrealised gains and losses also tend to increase contributing further to improved profit margins. Income statements and balance sheets might also become less conservatively stated as company management competes with ever higher earnings expectations. Artificially low interest rates also contribute to profit margins as they reduce finance costs and help drive gains of financial assets and intercorporate investments.

Combined these factors help explain why profit margins frequently are at their widest during the latter stages of a bull market. For example, operating profit margins previously peaked in 2000/01 and 2006/07. As of Q3 2016, they are at record highs based on data starting in 1994 (Stock Market Briefing: S&P 500 Sectors & Industries Profit Margins, Yardeni Research, Inc., Figure 1, January 23, 2017).

Today, Shiller's CAPE ratio stands at 28.05 - the highest reported since the dot.com bubble. As we now enter another earnings season, investors should therefore contemplate that it is not just stock market valuations that are inflated, but earnings as well. Stock market prices dependent on ever-inflating corporate earnings and interest rates kept below their natural level are however only sustainable to the extent the rate of monetary inflation can continue to expand.

Since 2009, the money supply has expanded at an annual pace of more than 10%. The rate of expansion must however one day decline due to for example excessive price inflation or weakened bank balance sheets. When this happens, earnings will be negatively affected and stocks will look even dearer. This process has already been on its way for some time, though it has reversed somewhat in recent periods.

A slight tightening of monetary policy and reduction in the bank credit growth rate will however negatively affect the more recent trend. When it does, stock market valuations and earnings will both likely drop bringing about an even larger drop in stock market prices.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.