S&P 500's Key Engine Breaking Down Signals Steep Stock Declines

A key driver of bull market gains has been expanding profit margins, particularly for S&P 500 companies. Now the trend is reversing. The overall margin for the index peaked in 3Q 2018 and is heading downwards, and stock prices may follow.

“We definitely are declining on margins,” as Howard Silverblatt, senior index analyst for S&P Dow Jones Indices, told the Financial Times. He adds that the decline in 4Q 2018 S&P 500 margins is the biggest since 4Q 2015. 

Goldman Sachs, meanwhile, identifies 60 stocks with low profit margins that look vulnerable, including these 10: General Electric Co. (GE), Goodyear Tire & Rubber Co. (GT), United Continental Holdings Inc. (UAL), Hewlett Packard Enterprise Co. (HPE), Conagra Brands Inc. (CAG), MGM Resorts International (MGM), Ford Motor Co. (F), United Parcel Service Inc. (UPS), Carnival Corp. (CCL), and Tyson Foods Inc. (TSN). See table below.

10 Low Margin Stocks Vulnerable To Declines

(Gross Margin Contraction Over Last 2 Years)

  • Goodyear, -509 bps (basis points)
  • United Continental, -485 bps
  • GE, -472 bps
  • Hewlett-Packard Enterprise, -426 bps
  • Conagra Brands, -178 bps
  • MGM Resorts, -172 bps
  • Carnival, -156 bps
  • Ford, -101 bps
  • United Parcel, -69 bps
  • Tyson Foods, -49 bps

Source: Goldman Sachs,"U.S. Thematic Views," March 15, 2019.

Significance For Investors

"Steady increases in margins have been the stock market's secret sauce since the 1980s, allowing earnings to grow at a much faster clip than sales and pushing share prices higher as a result. If profit margins were merely to return to their levels of 20 years ago, then earnings--and share prices--might be 40% lower than they are today," according to a column in The Wall Street Journal.

Several factors have boosted margins: wages declining as a percentage of gross domestic income; corporate taxes falling from 32% of pretax profits in 2000 to 11% in the first three quarters of 2018; and increased market share for big companies that produced cost-cutting economies of scale. These trends are "unlikely to persist," the column concludes.

With wages on the upswing due to a decades-long low in unemployment, this trend already has reversed. Accordingly, Goldman advises investors to consider stocks with low labor costs.

"Rising inflation lifts nominal revenues but generally compresses profit margins, resulting in a mixed impact on corporate earnings," Goldman writes. "With input cost pressures high and likely to keep rising, companies will need to be more aggressive in raising prices or accept lower profit margins," they add.

"With margin pressures large and mounting, the equity market is rewarding firms with the pricing power to maintain their profits. We screen for pricing power by examining the level, variability, and recent momentum of company gross margins relative to sector peers," the report continues. Since May 2018, Goldman's list of 41 stocks with high margins and pricing power has outperformed 60 low margin and pricing power counterparts by 17 percentage points (13% gain versus a 4% loss).

General Electric, a troubled industrial conglomerate in a protracted restructuring effort, has problems beyond weak margins. Its massive debt burden raises the prospect of sharply higher refinancing costs and a possible downgrade to junk bond status.

Looking Ahead

"The common wisdom is that margins will weaken from here. We do not think that the potential consolidation needs to be very material," as Mislav Matejka, head of global and European equity strategy at JPMorgan, told CNBC. Contrary to conventional wisdom, he indicated that there is strong positive historical correlation between commodity prices and profit margins.

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