When real earnings have reached the current extreme in the past, a massive decline in earnings has followed. The bottom in earnings might come in the next recession in as little as two years, or it might take a couple of recessions and take ten years to reach the bottom.
Businesses are more leveraged with debt than they have been in at least 70 years and perhaps more than they have ever been.
In the previous few years, when the GDP growth rate is more than about 1.9%, leveraging with debt can be like rocket fuel for profits. When it’s below about 1.9%, debt can be like quicksand shrinking profits and perhaps consuming businesses. Non-financial business debt at 46.8% of GDP makes businesses 8.3% more leveraged than at the beginning of the Great Recession and financial crisis.
The rise in debt along with the rise in the 3-month T-Bill yield during the last two years may make debt service harder and require a higher GDP growth rate to prevent squeezing profit margins. The T-Bill yield leads after-tax corporate profits as a share of GDP by about 19 months. The rise in yield suggests that profits will drop from about 9.5% of GDP to about 6.5% in the next 19 months.
The profit margin for the S&P 500 using operating earnings as tabulated by the S&P Statistical service has recently been at 10%. The T-Bill yield suggests the margin will drop to 8% in 22 months.
Generally accepted accounting principles (“GAAP”) earnings also have a profit margin of 10%, but the best correlation with the T-Bill yield suggests the margin will fall to 7%.
Profit margins will likely be under pressure in the next 19-22 months. If a recession occurs in that period, margins will likely fall sharply below the levels suggested above.
S&P 500 earnings, especially real earnings, are above the long-term trend and are at a stage of the business cycle where growing slower than trend would be more normal.
In the last 80 years, GAAP earnings of the companies in the S&P 500 or an approximation of that index prior to its existence have grown at a 6.2% pace. Since the small profit recession ended in early 2016, earnings have grown at a 14% pace, and forward estimates of those earnings project that growth rate to the end of 2020.
A growth rate of more than twice the long-term average continuing when earnings are well above the long-term pace and the economy is 10 years into an economic expansion is highly unlikely. While it is normal for profits to have grown at a faster-than-average pace to this point in the business cycle, going forward slower-than-average growth, if not an outright decline in earnings, would be more normal.
Adjusting earnings for inflation shows a much bigger extreme. Most of the faster pace in earnings growth after 1937 as shown in the chart above was the result of higher inflation. If you take inflation out the long run, the best fit growth rate for real earnings is 1.5%.
Currently, real earnings (in black) are 2.55 times higher than smoothed earnings (in blue). On average, earnings are 1.7 times higher. We will comment on this further below.
Part of the reason real earnings are so much further above the trend line than nominal is that inflation has greatly moderated since stable prices were added to the Federal Reserve mandate in 1978. Inflation since 2007 has only averaged about 1.6% vs. 4.3% from 1937 to 1995.
Adding the inflation rate of 1.6% for the past twelve years to the 1.5% real earnings growth trend suggests the average nominal growth rate of earnings at present should be 3.1% rather than 6.2% or 14%. Earnings growth faster than the 3.1% rate may be counterbalanced by growth slower than 3.1% in the not-too-distant future.
Sometimes, it’s useful to look at data from a very long-term perspective. The next chart looks at the growth rate of the economy and real GAAP earnings over 36-year periods. This is roughly one demographic cycle, or the approximate time between the peak of one baby boom and the next.
During the 36 years ending March 2019, real earnings grew at a 4% pace, well above the 1.5% average. A growth rate at 4% or above happened three times in the past between 1955 and 1975. During those three times, the 36-year rate of GDP growth was also above average, which is not the case today.
The most recent 36-year GDP growth rate at 2.8% is up from 2.6% in 2015, which was the lowest since 1940. The improvement in the last three years came from displacing the 0.2% growth rate for the years 1980-1982 with the 2.2% growth rate from 2016-2018. In coming years, the strong growth during Reagan’s last 6 years will likely be displaced by much weaker growth. I expect the 36-year rate to hit its weakest level since 1939.
As mentioned above, real earnings are currently 2.55 times higher than the smoothed earnings. Earnings have only been this far above smoothed earnings 2% of the time. It was higher a quarter ago. The furthest earnings got above trend was in the profiteering during WWI. The second furthest was in the lead-up to the financial crisis. Following those two extremities, earnings declined about 90%.
It has taken record business debt, record low interest rates, a huge corporate tax cut, massive stock buybacks and perhaps accounting gimmickry to push earnings to the third-most extreme position in US stock market history. Earnings were not pushed by the economy, which has grown at a below-average pace for thirteen straight years. The fourth through sixth most extremely stretched periods were followed by earnings drops ranging from 41% to 67%.
Unwinding from this extreme may have already started. With about 20% of companies reporting Q1 2019 earnings, it appears real earnings for the 12 months ending March 1919 will be lower than those for the 12 months ending December 2018. Nominal earnings are on track to be slightly higher.
Even if the unwind has started, it does not mean the stock market (SPY) cannot make new highs. While I think there is a strong chance of recession in 2020, at this point I’m only forecasting weaker growth. My model suggests growth continues through 2019. While Q1 GDP is generally expected to be below 2% and my model suggests below 1%, the current quarter appears to be headed for growth above 3%.
Strong economic growth in the current quarter should mean reporting strong earnings starting in July. New stock market highs are possible, if not likely, for another five months, but unwinding the stretched earnings probably means an unfavorable risk-reward ratio after that, and conceivably a crash.
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.
Additional disclosure: There is no guarantee analysis of historical data their trends and correlations enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money.