Why the Bull Market Is More Fragile Than It Looks

(Bloomberg Opinion) -- A key foundation of the bull market may be thinner than it looks and closer to cracking.

The S&P 500 Index’s 12-month trailing net profit margin — that is the percentage of sales that make it all the way to the bottom line — hit 10.1 percent as of the third quarter, according to Bloomberg data. That was a milestone. It was the first time the profit margin of the broad market index reached double digits and was the product of a multidecade climb. The S&P 500 entered the 1990s with a profit margin that was half of what it is now. The gain has defied the bull market doubters, and even some worrywart CEOs, who have warned about coming weakness in profits.

Analysts expect net profit margins to continue to push higher next year and beyond, to nearly 12 percent in 2020, based on the latest numbers, but there are reasons to question that prediction. The strong job market appears to finally be pushing up wage growth, though still slower than expected. Tariffs are increasing raw material costs. Higher interest rates will lift borrowing costs and create another weight on profits. 

But the biggest problem is that margins are not nearly as strong as they appear, and for that investors can thank weightings and technology companies, according to Goldman Sachs’s chief U.S. equity strategist David Kostin. The S&P 500 index is weighted by market cap, and technology companies tend to have higher margins than other companies. So the run-up in the last few years of the big technology companies has made them a greater percentage of the index, which means the rise in the market’s net profit margin may be more mix than muscle. Kostin says 10 stocks alone, led by Apple Inc., Google-parent Alphabet Inc., and Facebook Inc., have been responsible for half of the margin expansion in the S&P 500 since 2009. Alphabet’s roughly 30 percent profit margin, for instance, boosted the S&P 500’s overall profit margin 6 percent in that time, even though Alphabet’s own profit margin dropped slightly during the same period.

Remove the information technology sector, and the S&P 500’s net profit margins are still up, but to just more than 9 percent, rather than 10 percent, according to Kostin. The profit margins of the technology sector on the other hand have shot up to 22 percent. 

That may make profits more vulnerable than they appear. Kostin cites margins as one of his main concerns for next year. He thinks overall profit margins will grow by about a third of what other strategists are predicting next year and start to fall the year after that. Already, analysts expect profit growth to slow to 9.7 percent next year from 24 percent in 2018. If big tech’s recent woes widen, the pillar that’s been holding up the bull market will suddenly be extra wobbly.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Stephen Gandel is a Bloomberg Opinion columnist covering banking and equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.

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