Too calm, too quickly? Too calm, too quickly? Too calm, too quickly?

Investors should not wish for an average equity market

Peter Garnry

Chief Investment Strategist

Summary:  Net profit margins are still fat in the S&P 500 sitting well above the historical average and revenue growth has recently also been strong. But what if the recent trajectory of margin compression continue pushing it closer to the historical average in the S&P 500 and revenue growth also comes down with the slowdown in nominal GDP? These are some of the scenarios we look at in today's equity update in order to calculate the sensitivity to the ongoing margin compression which undoubtedly is the most important risk factor for equities next year.

The margin compression dynamics are key next year for S&P 500

As Disney showed in their earnings release margins everywhere are coming down from their high pink skies as we have highlighted in our recent equity notes Earnings season fades with cyber security stocks in big plunge and Consumer industries are seeing growth and margin expansion in Q3. The margin compression dynamics have got little attention so far with the 20% decline in S&P 500 since the peak being mostly attributable to higher interest rates causing equity valuations to come down. But as we have highlighted in several of equity notes, net profit margins soared to all-time highs during the pandemic and the past five years have seen profit margins globally running well above their historical average. Inflation, higher interest rates and wage pressures will continue to impact margins negatively in 2023. How will it impact the S&P 500?

S&P 500 cash index | Source: Bloomberg

The current 12-month trailing net profit margin in the S&P 500 Index is 12.4% down only 0.1%-point from its peak a couple of quarters ago. Trailing figures are slow to capture quick changes and the Q3 net profit margin has declined to 11.8% from 12.7% in Q2, a big drop in a single quarter. The 12-month trailing revenue growth is 14% compared to a year ago. If we assume that the net profit margin will decline to the historical average since 2002 at 9.3% and revenue growth slows to around 7-9% consistent with the lag from nominal GDP growth then the S&P 500 could see a price range indicated by the green rectangle. This assumes no change in the P/E ratio. The average of those values in the green rectangle is 3,223, which not far from our target on the S&P 500 of 3,200 and would constitute to 16% decline from the current level. If the S&P 500 sees net profit margin going to the historical average of 9.3% and revenue growth also hitting the historical average of 5% then the valuation is 2,969 assuming no change to the P/E ratio.

If we assume lower margins also coincide with a slowdown in the economy the equity risk premium might increase, that is at least historically been the case, which in turn would lower the P/E ratio unless interest rates decline a lot next year. The current difference between the US 10-year yield and the earnings yield on S&P 500 is 1.3%-point which is half of the historical average since 2002. If we assume a decline in the net profit margin to 9-10% next year, revenue growth of 7-9%, and an earnings yield premium over US government bonds back to the average at 2.6%-point the we get a different valuation area as observed in the green rectangle. The average price here is 2,615 around 32% lower from the current level.

If assume the most extreme scenario over the next 4-5 quarters of the equity market going back to the long-term average on all variables then the valuation is 2,409. This figure is so shocking that nobody would wish an average equity market but instead a more inflated one while we ride out the inflation wave. What is our base case scenario based on the current trajectory, assuming no severe recession but a shallow one with nominal GDP pacing on? That would be the net profit margin down to 10% (so still above the average) and revenue growth around 8-9% with the P/E ratio falling from 18.5x today to around 17x which translates into around 3,130 on the S&P 500 which is a bit below our 3,200 level that we have put out as our target for when the market bottoms. But with everything else in life the circumstances change all the time and many things could move our prediction such as the war in Ukraine, China’s degree of success with its less strict Covid restrictions, inflation and wage dynamics, and finally the energy market.

How to set up the portfolio against the margin compression

The past year the margin pressure has been the biggest industries such as media & entertainment, financials, banks, semiconductors, utilities, real estate, and health care equipment. On the flipside industries such as energy, insurance, transportation, retailing, software, and pharmaceuticals have preserved or even expanded their margins. Based on the expected margin compression dynamics in 2023 we recommend investors balance their portfolios away from the hardest hit industries as things could get even worse. This idea overlaps with our thesis the physical vs digital world. Another way to reduce risk during margin compression is to hedge the portfolio using instruments that rise in value when the S&P 500 or another equity index falls in value.

On a single stock basis the list below highlights the biggest companies in each of the categories mentioned as those that have preserved or expanded their operating margins. The list is for inspiration and should not be viewed as investment recommendations.

  • Exxon Mobil
  • Chevron
  • Shell
  • Allianz
  • Chubb
  • UPS
  • Union Pacific
  • Microsoft
  • Visa
  • Oracle
  • Johnson & Johnson
  • Eli Lilly
  • Roche

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