SPY: The S&P 500 Will Be Increasingly Reliant On Revenue Growth

Summary

• Revenue and earnings estimates are fairly high in the face of a global economic slowdown.
• Profit margins are at a cyclical high and a secular high suggesting the ability to pull profit levels may be limited.
• The S&P 500 will be increasingly reliant on generating top-line revenue growth to meet elevated EPS estimates.
• Earnings growth in the US is likely to fall well short of what is priced into the market over the next 12-18 months.
• This idea was discussed in more depth with members of my private investing community, EPB Macro Research. Start your free trial today »

SPY: The S&P 500 Will Be Increasingly Reliant On Revenue Growth

As the S&P 500 has moved higher over the past six weeks with the SPDR S&P 500 ETF (NYSEARCA:SPY) rallying more than 16% off the low set on Christmas Eve, nearly all fear has come out of the market and the sense of optimism is back, despite the lack of a change in underlying growth fundamentals. What is currently priced into the market today in terms of revenue growth and EPS growth for the S&P 500 and, thus the SPY ETF, is far too optimistic for the current environment, and has the potential to lead to a fairly rapid contraction in EPS estimates.

With profit margins at a cyclical and secular high, something that was recently discussed in the member chatroom of my marketplace service, EPB Macro Research, the ability for companies to pull profit levers on decelerating revenue growth is diminished, creating an environment where the S&P 500 companies that comprise SPY will be increasingly reliant on companies delivering on the top line.

What is currently priced into the equity market is highly optimistic based on the global growth outlook. The results through 2019 and 2020 have a high probability of falling short relative to expectations.

In an interview with Business Insider, Bob Prince, Co-CIO of Bridgewater Associates, the world's largest hedge fund, said that "earnings in the US are likely to underperform what is priced in." Below we will take a look at why Bridgewater is forecasting a sharp reduction in earnings growth relative to what is priced in, and what that may mean for the market and SPY as a whole.

The estimates for SPY earnings per share based on the S&P 500 have been coming down in recent weeks as the global slowdown continues to remain a constant downside risk. Interestingly, the market has only lowered the EPS estimates for the S&P 500 very briefly, forecasting that robust EPS growth will bounce back after a tiny blip. This is likely far too optimistic as will be outlined below.

S&P 500 EPS Estimates:

Source: Bloomberg

Analysts can argue at ad nauseam about the slowdown in the United States with an equal crowd on both sides of the debate but the global slowdown, at this point, is not subject to the same controversy.

The global economy, as I will show below, is experiencing the sharpest slowdown in economic activity since the 2015-2016 economic slowdown. That is not to say a recession is imminent in the US or in the global economy but the data suggests the probability of a recession in Europe is certainly rising with Italy officially in a recession and Germany not too far behind.

The last time there was a global economic slowdown, as outlined in the middle of the chart below, there was a contraction in top-line revenue growth and essentially flat top line figures for two years.

Today, despite the fact that the S&P 500 generates a significant amount of revenue from overseas, revenue is estimated to rise at a robust pace even while global growth is slowing in some areas and outright contracting in others.

S&P 500 Revenue Per Share:

Source: Bloomberg

Similarly, during the last global economic slowdown, S&P 500 earnings per share experienced what some call an earnings recession, before rebounding higher along with global growth in 2017 and the start of 2018.

Why is the market currently pricing in the fact that the S&P 500 revenue and earnings will be immune to this current global slowdown, which can be argued is nearly just as bad as 2015?

S&P 500 EPS:

Source: Bloomberg

Currently, the S&P 500 is priced for 4.8% revenue growth in 2019 and 5.0% revenue growth in 2020, despite the sharp contraction in economic activity globally that led to flat revenue growth just three years ago.

S&P 500 Revenue Forecast:

Source: Bloomberg

On 4.8% and 5.0% revenue per share growth, the market is estimating that companies will generate 6.8% and 10.6% EPS growth for 2019 and 2020. Again, these are fairly robust estimates given the global outlook.

S&P 500 EPS Forecast:

Source: Bloomberg

Here is where the rubber meets the road.

The S&P 500 is not only at cyclical highs in terms of profit margins, but S&P 500 companies are also currently experiencing secular highs in profit margin indicating that they are unlikely to be able to pull profit levels and generate 6%-10% EPS growth if revenue falls short of estimates.

It should also be noted that profit margins contracted during the last economic slowdown.

Today, the situation is even worse for profit margins as the end of an economic cycle is starting to bring rising cost pressure from wages and inputs. Bob Prince, in his interview, added, "adding to that pressure is a decent amount of embedded expenses priced into the equity market, meaning that corporations have extrapolated the good times forward in terms of their expense base so there is some operating leverage in top line growth. If top-line growth slows in an environment of slowing global growth, that could have a more magnified impact on the bottom line due to secular high profit margins and embedded cost structures."

Even if you do not believe Prince, the cyclicality of profit margins suggests the likelihood of profit margins remaining at both cyclical and secular highs for an extended period of time is low, irrespective of the global slowdown.

The market is currently pricing the S&P 500 for mid-single-digit revenue growth in the face of a sharp economic slowdown globally with virtually no impact to profit margins which are at nearly all-time highs for the S&P 500.

S&P 500 Profit Margin TTM:

Source: Bloomberg

Profit margins are highly cyclical and thus mean reverting. Below is a proxy of corporate margins for all equities showing that corporate margins are at the highest level since the 1940s. The mean-reverting nature of the time series is also suggestive that the bias for margins is to move lower in the coming years, not higher.

Flat to down profit margins, even if companies deliver on revenue growth, will cause EPS to fall short of what is priced in.

Prince continued, "You are discounting high earnings growth while profit margins are at secular highs and from a secular perspective, you have a series of forces that will be working against profit margins. You are on the backside of both fiscal stimulation and monetary stimulation."

US Corporate Profit Margin Proxy:

Source: Federal Reserves, FRED, EPB Macro Research

The global economic slowdown is not a debatable point with the global composite PMI reading falling sharply and the global manufacturing PMI sitting at 50.7. The global manufacturing PMI suggests that the global manufacturing industry is near a contraction, let alone a slowdown.

It can be debated when this will reverse but we are deep into Q1 and these pressures have not subsided, they have only gotten worse, and this impact has not been reflected in earnings yet.

Prince updated the outlook for Bridgewater saying, "Our best guess is that we will get a global slowdown. We’ve gotten one. We think it will continue."

If Prince and Bridgewater are correct, and the global slowdown continues, how will the S&P 500 generate positive revenue growth?

If revenue falls short of consensus, based on a secular high in profit margins, the ability of corporations to pull levers to generate strong EPS growth off weaker than expected revenue growth is severely diminished.

Global PMI Readings Demonstrate Global Slowdown:

Source: Bloomberg

While corporate buybacks are still going to be a positive force in the market for S&P 500 companies, with share counts falling, the recent widening of corporate bond spreads is going to reduce the growth rate of buybacks on the margin.

Corporate spreads have come down rather sharply since January as the equity market has rallied but taking a longer-term view shows that spreads are materially wider since the beginning of 2018. Higher corporate spreads will reduce the ability of corporations to roll debt or issue new debt to fund higher rates of buyback growth.

Corporate Bond Spreads Trending Higher:

Source: Bloomberg

The correlation between higher spreads and lower buyback growth has been proven by Pervalle Global. Below is a chart that shows the year over year change in corporate spreads leading a year over year decline in buyback growth. The recent widening of corporate spreads that we have seen will be a force working against future buyback growth.

Buybacks will still be positive, but the growth rate in share buybacks is likely to be reduced in the years ahead as the cost of funding is rising and spreads are widening.

Buybacks Are At Risk With Rising Spreads:

Source: @TeddyValle

This is not an insignificant issue as the effective yield on BBB-rated corporate bonds is near the highest level since 2011 despite the actual spread remaining fairly low as interest rates have increased across the curve from 2016-today.

BBB-Rated Effective Yield:

Source: BofA, EPB Macro Research

With all of these factors to consider, the S&P 500 is about 7% off the all-time high set in September of 2018.

S&P 500:

Source: Bloomberg

To summarize the level of risk in the market today into one key element is simply the fact that estimates are just too high.

Is the US economy going into a recession? That is not in the data yet, but that does not mean that the S&P 500 will be able to generate 5%-6% revenue growth for the next two years in the face of a near global recession in some major parts of the world. Add on top of that the fact that corporate profit margins are at both a cyclical high and a secular high with a high expense base extrapolated into the future and the top-line operating leverage is quite high relative to past years of this economic cycle.

At this current juncture, based on what is priced into the equity market relative to what is likely to materialize given revenue growth, EPS growth, and profit margins, the bigger risk today is in the financial markets than in the real economy. That may change in the future but the probability suggests the global slowdown will persist, bleeding into the United States with the leading indicators pointing lower.

There is not likely to be an "air pocket" effect in the real economy, not yet, but the top line operating leverage with cyclically high-profit margins and optimistic revenue and EPS forecasts in the fact of a severe global economic slowdown mean that earnings are likely too high for the US market.

The S&P 500 will be increasingly reliant on delivering strong top-line growth to generate the level of EPS growth that is priced in and the evidence of a downshift in global growth makes that a difficult proposition.

The level of risk in the market today is quite high. That is not to say that the S&P 500 will fall tomorrow but over the next year, the highest probability outcome is that estimates will be slashed rather sharply. The market can continue higher if the multiple expands while estimates are being cut, that is possible, but the risk is higher today and thus, I'd consider an underweight position in SPY or equities in general relative to your preferred asset allocation.

What is priced into the equity market suggests that nearly everything will go right and not a lot will go wrong in the next 12-18 months. The global economic data doesn't support that view.

Analyst’s Disclosure: I am/we are long SPY. 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.

I have an underweight allocation to SPY