Introduction

Corporate profit margins continue to defy the expectation of mean reversion, defying the long-held belief that high margins will eventually come down while low margins will rise. This is evident in the case of S&P 500 companies over the past three decades, as shown in the chart below. Instead of reverting to historical means, profit margins are reverting to a rising trendline.

The Unconventional Bull Argument

Traditionally, continued rise in profit margins would be considered unsustainable, as it would attract excessive capital and result in diminishing returns. However, proponents of a new era argue that the advent of artificial intelligence (AI) changes everything. They believe that AI-driven productivity growth will be limitless, leading to exponential returns on capital.

Skepticism is Warranted

While the narrative of an AI-driven revolution may seem enticing, investors should approach it with caution. History has shown that “new era” narratives often lead to excessive exuberance and subsequent market bubbles. The phrase “this time is different” has proven to be the most dangerous on Wall Street.

The Future of the Stock Market Hinges on Profit Margins

The bullish proponents of the “new era” narrative rely on its validity to justify the current high valuations in the stock market. However, even if profit margins were to remain constant at their current levels, without any further increase, it would have significant implications for the future trajectory of the market. It is important to recognize that this assumption is already generous, as profit margins could potentially decline significantly.

The Limitations of Stock Market Growth

Without margin expansion, the growth of the stock market relies on two factors: sales growth and P/E expansion. However, neither of these factors guarantees strong future returns.

Sales Growth

It is difficult to envision corporate sales outpacing overall economic growth in the long term. Economic projections for the next decade indicate slower growth compared to historical averages. The non-partisan Congressional Budget Office estimates that real GDP growth will average just 2% annually over the next ten years.

Even this estimate seems optimistic since historically, sales growth has lagged behind GDP growth by around 0.9% annually, according to Rob Arnott, founder of Research Affiliates. Therefore, if this pattern persists and the CBO estimate holds true, sales growth will average just over 1% annually in the coming decade.

P/E Expansion

The current P/E ratio of the S&P 500, based on trailing 12-month earnings per share, is 24.8. This figure is 55% higher than the long-term average of 16.0 since 1871. Additionally, the cyclically-adjusted price/earnings ratio (CAPE) of the S&P 500 stands at 32.6, almost double its historical average of 17.4.

In summary, if the market’s P/E multiple remains elevated, the S&P 500 is expected to outpace inflation by only around 1% annually in the next decade. However, if this multiple experiences a significant decline, caution should be exercised.

Also read: If this is all the downside the bears can deliver, then the bull market may still be intact

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