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Good-as-It-Gets Bear Case on Stocks Keeps Drowning Out Earnings

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(Bloomberg) -- It’s not what have you done for me lately. For companies in the S&P 500 Index, it’s what will you do for me next. And that’s proving a thorny question for U.S. equity bulls.

Another week of stellar earnings reports has gone by without any payoff in stocks. Even Friday’s rally, the biggest in almost a month, couldn’t turn the tide. Sure, Apple Inc. had its best week since Barack Obama’s first presidential term, and Mastercard Inc. shrugged off a push by Amazon.com Inc. in online payments. But even as analysts raised S&P 500 profit forecasts for each of the next three years, the benchmark gauge for U.S. equities was flat.

The issue is whether to believe the analysts. Companies could hardly be doing a better job of fattening profits or buying back stock at present. But forces have gathered that lead some investors to wonder if enthusiasm for the future isn’t a little stretched.

“Perfection is priced in,” said Robert Parks, managing director at RJ O’Brien & Associates LLC in Chicago. “S&P earnings are spectacular, but it would be difficult to continue that, and that’s what the market is worried about.”

One concern is profit margins, the difference between revenue and expenses. With the cost of everything going up, how long can U.S. companies keep sending dollars they get in sales to the bottom line? It’s a creeping anxiety. Using earnings before interest and taxes, S&P 500 margins stand at 13.7 percent, according to Fundstrat’s Thomas Lee. They reached a record 14.04 percent in December 2014.

With the 10-year Treasury yield flirting with 3 percent, labor costs creeping higher and commodity prices up, anxiety about margin compression has swirled. Michael O’Rourke, JonesTrading’s chief market strategist, said he heard budding anxiety about rising input costs in quarterly commentary from companies as diverse as Caterpillar Inc., 3M Co. and Paccar Inc.

“All of these costs now exist, and are rising in a way that they haven’t for a decade or more,” said Michael Shaoul, the head of Marketfield Asset Management. “It’s too early to tell whether corporate management can pass them on.”

Despite a 6.6 percent gain in Alibaba and a 13 percent surge in Apple, the S&P 500 declined for a second week, slipping 0.2 percent. The Dow Jones Industrial Average lost 49 points, while the Nasdaq 100 Index rose 1.7 percent

Margin deterioration has the potential to terrify bulls because of how much earnings optimism is baked into the S&P 500’s valuation. Even after falling 7.3 percent from its January record, the index still fetches a 20.5 times earnings in the last year. Looking forward, to projected 2018 earnings, the multiple falls to a more palatable 16.2. Based on 2019 expectations, it’s a relatively cheap 15.3.

Getting there won’t be easy, however. S&P 500 companies are in the process of reporting profit growth of 24 percent in the first quarter, the most since 2010, and they must repeat that all year to hit analysts 2018’s target of $158.30 a share. Then profits will have to rise an additional 10 percent in 2019 to hit that year’s target.

An increase in inflation is anticipated in those numbers, but probably not a rapid one, particularly in raw materials. General Motors Co.’s costs tied to higher commodity prices will be up to $400 million higher than was expected in January, the company said last month. A $470 million increase in commodity costs is to blame for lower earnings in Ford Motor Co.’s auto sector.

Lee, Fundstrat’s head of research, says there’s nothing to worry about. Only four S&P 500 sectors -- tech, utilities, real estate and consumer discretionary -- have margins at or near record, he said in a note. The others have room to expand.

Longer term, what matters is the pace of growth in inflation and interest rates, said Bruce Bittles, chief investment strategist at Robert W Baird.

“For months we have been talking about an uptick in inflation and yields reaching 3 percent and the economy approaching a full employment, and here we are,” Bittles said. “Margins are not going to collapse, but I do think that profit margins are going to be more narrow at the end of the year.”

©2018 Bloomberg L.P.

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