Investors buying the SPX on the basis of expectations of continued earnings growth are likely to be very disappointed as a combination of profit margin mean reversion and slow GDP growth cause earnings to stagnate for years to come. The forward P/E ratio of 18x is already expensive from a historical perspective and this figure is set to rise sharply in the absence of a large decline in the SPX.
Profit Margins Have Peaked And Free Cash Flows Suggest A Further Decline
Reported profit margins on the SPX peaked in February 2022 at a record high of 12.8%, and despite this figure having since fallen to 11.9%, it remains almost 50% above its 30-year average. If we look longer term, the average profit margin for the SPX has been around 6%, similar to the economy as a whole, meaning current margins remain extremely elevated from a historical perspective.
If we look at free cash flows instead of earnings, we can see that margin mean-reversion has already begun in earnest. The profit margin on the SPX ex-Financials index is currently at just 8.9%, having fallen by over 2pp from its peak.
The forward P/E ratio of the SPX ex-Financials sits at 19.1x, which is based on earnings rising 4% over the next 12 months. However, in order for the price-to-free cash flow ratio to fall to 19.1x we would need to see a staggering 37% rise in free cash flows from trailing 12 month levels, which would take margins back to all-time highs.
Rather than a surge in free cash flows, we are more likely to see a decline in earnings as has been the case in the past. As shown below, when earnings per share have dramatically exceeded free cash flows in the past, the correlation has been reestablished by a fall in earnings rather than a rise in free cash flows.
Nominal GDP Growth Should Average Below 3%
In a recent article on inflation-linked bonds (see ‘LTPZ: Real Yields May Need To Move Back Below Zero To Prevent A Fiscal Meltdown‘), I argued that real GDP growth in the US is likely to average around zero percent over the next decade. To see why, consider that over the past 10 years real GDP growth has averaged 2.2%, which can be broken down into 1.2% growth in employment and 1.0% growth in output per worker. We can further break down employment growth into the growth of the working-age population and the change in the unemployment rate, both of which contributed around 0.6% per year to real GDP growth.
Over the next 10 years we should see growth in the working age population continue to slow to perhaps half of that figure, suggesting future real GDP growth will be capped at 1.3% even if productivity growth halts its long-term decline and the unemployment rate remains near record lows. It would therefore take a rise in the employment rate from the current level of 3.6% to just 4.1% by 2033 to result in zero real GDP growth over the next decade. A rise in the unemployment rate to just 4.5% would be enough to cause US real GDP to average -1% over the next 10 years.
As equities are real assets that tend to rise with inflation over the long term, nominal GDP is a more important figure to consider. Based on 10-year breakeven inflation expectations, CPI is expected to grow by an average of just 2.4% over the next decade. While I am sympathetic to the idea that bond investors are underestimating long-term inflation, this would still be a full percentage point above the decade preceding the record 2020 monetary expansion. It is also worth noting that this monetary expansion has now begun to reverse, with M2 money supply dropping 1.7% y/y in January, thanks to a 5% contraction in the Fed’s balance sheet.
If we add this inflation outlook to expected real GDP growth, this suggests nominal GDP and SPX sales growth of around 2-3% per year. If profit margins were to contract by just 2pp from current levels as reported earnings converge to free cash flows, this would wipe out all the returns from revenue growth for up to 8 years.
A Crash Is The Most Likely Scenario
The real threat facing many SPX investors is not a long period of near-zero returns but a sharp decline that lifts future return prospects back on par with historical norms and current borrowing costs. Many SPX bulls who bought this time last year on the basis that extreme valuations were justified by low bond yields remain bullish despite the surge in bond yields pushing the equity risk premium negative. While market crashes are rare and always take the majority of investors by surprise, they are anything but random. For instance, 20% SPX declines have occurred once every 6 years on average since WWII, with half of these bear markets resulting in the SPX losing at least one third of its value. On each of these occasions, expensive valuations were joined by rising bond yields, triggering a simultaneous decline in earnings and valuation multiples.
Under the growth assumptions outlined above and current long-term bond yields, it would take a ~70% decline in the SPX in order for the equity risk premium to rise back to its long-term average of 5% based on the most reliable valuation metrics as used by John Hussman. My sense is that bulls will be lucky if we do not see the SPX decline by another third over the coming years as current conditions resemble those of the major market peaks of the past.