There is a renewed sense of bullishness on Wall Street, but stocks may be at risk of a major pullback that could send equities into bear market territory. Equity prices have raced far ahead of earnings growth during the past 12 years, creating unsustainable valuations and thus making a stock market plunge of 25% or more very possible, according historical data. That risk is detailed in a feature-length report in Fortune summarized below.

"It's important to emphasize again that profits are already at ultra-high levels measured by operating margins and share of national income, leaving not only little room to grow, but raising the risk of a steep decline," Fortune states. "What if earnings drop by 10%, a common phenomenon that occurred after peaks in 2000, 2006, and 2014," Fortune says. "In that case, the S&P 500 would shed more than a quarter of its value."

Key Takeaways

  • Stock prices, and valuations, have risen faster than earnings since 2007.
  • The divergence has been even wider since 2014.
  • Forecasts of profit growth in 2020 appear much too optimistic.
  • The likelihood of a major stock market selloff is rising.

Significance For Investors

Fortune calls this possible 25% selloff a "correction," but a decline of 20% or more is the common definition of a bear market, or least entering bear market territory, however brief that may be. A correction normally is defined as a pullback of 10% or more, but less than 20%. Fortune did not offer a timeframe on when a 25% selloff might begin, or how long it might last.

Profits for the S&P 500, as measured by four quarters of trailing earnings per share (EPS), hit a pre-financial crisis peak in Q2 2017. At the point, the trailing price-to--earnings (P/E) ratio for the index was 17.8 times earnings. From Q2 2017 to Q2 2019, trailing EPS for the index has risen by 59%, but the index itself has surged by 106%.

As a result, the valuation of the S&P 500, as measured by its trailing P/E ratio, has jumped from 17.8 to 23.0. The inverse of the P/E ratio, the earnings yield on the index, thus has fallen from 5.6% to 4.3%. Looked at in yet another way, for each dollar invested in the S&P 500, the buyer is getting 23% less (4.3% divided by 5.6%) in annual earnings today than he or she would have received 12 years ago.

In the past 5 years, since a previous earnings peak, the divergence between profit growth and stock prices has been even wider. Since then, trailing S&P 500 EPS is up by 28%, but the index has risen by 57%, more than twice as fast.

The consensus among analysts polled by S&P is that earnings will increase by 24% between now and the end of 2020. If so, and if stock prices remain unchanged, that would send the trailing P/E ratio for the S&P 500 soaring.

However, corporate profits now represent 9.8% of U.S. GDP, significantly above their long-term value of 7.5%. If profits surge by 24% over the next year, they would be 12% of GDP, all else equal. Meanwhile, the operating profit margin for the S&P 500 is currently 11.3%, the highest in a decade, and well above the average of 9.5% since 2010. For bottom line profits to jump by 24%, operating margins would need to rise sharply. These scenarios are "unheard of," says Fortune.

Looking Ahead

Other analysts see more headwinds. Stagnant wages and falling borrowing costs had been big factors boosting profits recently, but these trends are now reversing. Meanwhile, the corporate tax cuts enacted in late 2017 put after-tax profits on a higher plateau, but most of their impact on the rate of profit growth was seen in 2018.

Barry Bannister, head of institutional equity strategy at Stifel Nicolaus & Co., believes that the Federal Reserve switched from raising rates to cutting them too late to avert another big stock market selloff, based on his analysis of the three previous crises that began in 1998, 2000, and 2007, as reported by Business Insider.

Morgan Stanley also shares Fortune's skeptical outlook on earnings growth. They expect EPS estimates for the next 12 months to begin falling, per a recent edition of the Weekly Warm Up report from their U.S. equity strategy group led by Mike Wilson. Moreover, Morgan Stanley's 2020 Global Strategy Outlook report, released this week, states that "US risk assets are too expensive for the modest [economic] pick-up we forecast."