Corporate profitability during our six-year bull market has been high relative to historical averages. Looking back, the combination of low interest rates and cost cutting measures have resulted in a spike in corporate profits that encouraged equity prices to march northward. Today the general equity market (the S&P 500 Index) is trading at over 17x forward earnings due to robust corporate profits.
We can see corporate profitability relative to history for the last 20+ years in the graphic below.
*Chart Source: FactSet and Fidelity Investments
The biggest driver of improving corporate margins over the past six-plus years has been expense reduction, not top-line revenue growth. Reductions in cost of goods, conservative hiring practices, low interest rates and other expense efficiencies have contributed to improving margins and a rising stock market. As mentioned above, we now find the market trading above its historical average of 15x earnings with a market multiple of over 17x corporate earnings.
Increased Corporate Spending
Looking forward, we are starting to see signs that corporate profit margins may peak and trend back towards historical averages. In addition, interest rates are expected to rise which will play a big role in margins going forward. Corporations may also start to spend again in an effort to lock-in interest rates before they start rising.
One leading indicator of corporate spending is in the labor market. Looking into the labor market we can monitor wage pressures, which are a leading indicator for improving consumer sentiment and eventually inflationary pressures. In the below graphic, we note that a trend of modestly rising wage inflation is unfolding as the labor market tightens and corporations continue to hire.
*Chart Source: NBER and Fidelity Investments
The Effect of Wage Pressures
Wage pressures should start to constrain corporate profit margins going forward. In addition, these trends within labor markets should encourage the Federal Reserve to begin the process of raising interest rates later this year. While the U.S. economy remains in the expansionary phase of the economic cycle, wage inflation and future Fed action will likely impact the stock market going forward.
The combination of higher valuations and more muted earnings growth are being accounted for within our portfolios’ asset allocation. In addition, we continue to monitor these trends relative to current near-term favorable accommodative policy, low inflation and the continued modest global economic improvements. Rest assured that as we monitor market conditions, we will be both proactive and protective in the management of your assets with Retirement Advisors of America.
As always, we will continue to keep you updated. We can be reached at 800-321-9123 with any additional questions.
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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.