Investors Are Overlooking One (Big) Thing: "Profits"

As mid-year approaches, helping support from falling rates and the hints of more monetary accommodation from the Fed has driven the impressive double-digit gains in equity markets. Yet, corporate profits, the ultimate driver of equities, have weakened, with two sequential quarterly declines already on the books and more declines likely ahead given the weak macro sales trends and declining margins. When will profits begin to matter again to investors?

According to the Bureau of Economic Analysis (BEA), operating profits in Q1 2019 declined 2.8% from the fourth quarter of 2018, and that comes on the heels of a small (0.4%) decline in Q4. The decline in operating profits is broad-based, with nonfinancial companies faring a little worse, declining 3% in Q1 and 0.6% in Q1.

Top-line revenue growth has clearly slowed. In Q1, nominal GDP growth of 3.6% annualized was the slowest in three years, following a gain of 4% in Q4. However, for the corporate sector the GDP data indicates overall revenue growth was less than 1% annualized for each period.

Profits margins are also being squeezed. According to the GDP data, real profit margins for the nonfinancial corporate sector in Q1 were 12.9%, more than two full percentage points off of the cyclical high of 15.2% reached five years ago.

Profit margins are heavily influenced by the ups and downs of the business cycle in that they bottom at the start of the cycle, hit a peak around the middle or a little bit later in the cycle and then start to decline as the growth cycle ages and costs of doing business start to rise faster than business itself. As such, it is hard to make a bullish case for corporate profits to resume an upward climb due to a rebound in operating margins.

At what point will profits matter to investors is hard to say as investors appear to be placing more weight nowadays on future growth opportunities than current profits. To be sure, a number of unprofitable companies have gone public this year, with several of the new firms share price soaring from the initial public offering price while others have seen their share price slip. As a group, however, investors have given these new publically traded unprofitable companies a market capitalization well into the hundreds of billions.

A recent study of companies that went public in 2018 showed that the share prices of newly traded public companies that were unprofitable fared much better when compared to those that were profitable at the outset. To be fair, the sample was relatively small (about 20 companies in total) yet it still showed how investors placed more emphasis on a business model that “promised” profits than on a business enterprise that was already profitable.

In the end, it all comes down to the simple question of how much are investors willing to pay for current and the prospect of future earnings? Based on current sales and costs trends Q2 operating profits are likely to be below that of Q1, off 2% to 3%, extending the consecutive decline in quarterly earnings to three, and the 2H outlook looks to be soft as well, with bottom-up estimates of equity analysts projecting modest declines.

Nevertheless, investors seem to be willing to overlook the negative trends in profits (as well as outright losses) and base their investment (equity) expectations on the belief that policymakers will be able lower rates, speed-up growth, make profitable companies more profitable and unprofitable companies profitable. This bullish prophecy could soon run into the realization that the weak growth and profit trends are not the result of interest rates or overall financial conditions and that monetary policy has reached the outward bounds of its effectiveness. When investor sentiment shifts, as it surely will do at some point, profits will matter (a lot) and companies that don’t have a clear path to profitability will get hit the hardest.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.