• 350 days Will The ECB Continue To Hike Rates?
  • 350 days Forbes: Aramco Remains Largest Company In The Middle East
  • 352 days Caltech Scientists Succesfully Beam Back Solar Power From Space
  • 751 days Could Crypto Overtake Traditional Investment?
  • 756 days Americans Still Quitting Jobs At Record Pace
  • 758 days FinTech Startups Tapping VC Money for ‘Immigrant Banking’
  • 761 days Is The Dollar Too Strong?
  • 762 days Big Tech Disappoints Investors on Earnings Calls
  • 762 days Fear And Celebration On Twitter as Musk Takes The Reins
  • 764 days China Is Quietly Trying To Distance Itself From Russia
  • 764 days Tech and Internet Giants’ Earnings In Focus After Netflix’s Stinker
  • 768 days Crypto Investors Won Big In 2021
  • 769 days The ‘Metaverse’ Economy Could be Worth $13 Trillion By 2030
  • 769 days Food Prices Are Skyrocketing As Putin’s War Persists
  • 772 days Pentagon Resignations Illustrate Our ‘Commercial’ Defense Dilemma
  • 772 days US Banks Shrug off Nearly $15 Billion In Russian Write-Offs
  • 775 days Cannabis Stocks in Holding Pattern Despite Positive Momentum
  • 776 days Is Musk A Bastion Of Free Speech Or Will His Absolutist Stance Backfire?
  • 776 days Two ETFs That Could Hedge Against Extreme Market Volatility
  • 778 days Are NFTs About To Take Over Gaming?
Is The Bull Market On Its Last Legs?

Is The Bull Market On Its Last Legs?

This aging bull market may…

What's Behind The Global EV Sales Slowdown?

What's Behind The Global EV Sales Slowdown?

An economic slowdown in many…

Another Retail Giant Bites The Dust

Another Retail Giant Bites The Dust

Forever 21 filed for Chapter…

  1. Home
  2. Markets
  3. Other

It Turns Out That Margins Matter

A mild surprise on Monday afternoon from Alcoa, which beat a significantly-lowered consensus estimate, wasn't enough to sustain stocks overnight. Another pulse higher came when the broader group of European finance ministers completed the Memorandum of Understanding (MoU) for the Spanish bailout, which included a provision for €30bln of the money by the end of the month. This rally too failed, and the reason Bloomberg cited was funny.

Bloomberg said "U.S. Stocks Fall on Earnings Pessimism..." According to the article, "profits for the entire S&P 500 are projected to have fallen 1.8 percent."

That's funny, because it suggests that this is somehow a surprise, today. Analyst forecasts have been coming down, to be sure, but they've been weak on Q2 for a long time. And profit margins have been at very high levels for a while now (see Chart, source Bloomberg), so downward pressure was overdue.

Traling 12m Prift Margin, SPX Index

Combine weak growth with rising cost pressures and you will eventually get margin compression. The chart below (Source: Bloomberg) shows the spread of core CPI minus core PPI, in white, plotted against the trailing 12-month EPS of the S&P 500. Note how when the spread of output prices (CPI) compared to input prices (PPI) is widening, it augurs well for profits one-year or so forward, and vice-versa.

margin compression

Really, the remarkable thing is that earnings have remained elevated for so long, even though producer prices have been increasing faster than consumer prices for a while now. My theory is that since that spread is narrow, and the labor market is very weak, there were ample opportunities for employers to squeeze just a bit more out of their workers. This shows up, of course, in improved margins. But - and just as important, if not more so - it is a game that cannot continue forever. Unless producer prices stop rising faster than consumer prices, earnings are going to come back down to earth. So investors find themselves with a bit of a conundrum. If CPI accelerates, this is good for earnings (as long as it outpaces PPI!) but bad for multiples historically. If CPI stays down, then unless producer prices slacken appreciably, the current earnings are unsustainable. I will say it again: stocks shouldn't be up here.

Incidentally, I wouldn't read too much into the apparent correlation of levels on the chart above. Over time, the yellow line will clearly move up and to the right, while the white line is designed to be mean-reverting. If I had the data, I'd make the yellow line the year-on-year change in earnings and see how the correlation holds up over time.


This is my last article for a couple of weeks. I am going to be traveling to Texas and Colorado, with family and to visit family, until late in July. Enjoy the silence!


Back to homepage

Leave a comment

Leave a comment