Research Affiliates: Peak Profits

February 01, 2016

Key Points

  1. S&P 500 as-reported EPS fell 14% from 2014 Q3 to 2015 Q3, one of only four drops of similar magnitude over the last 25 years, and each roughly coincided with a double-digit price decline in the U.S. equity market.
  2. In the 12 months ended 2015 Q3, valuation multiples expanded by an amount roughly equivalent to earnings' contraction, but in early 2016 prices are rapidly adjusting.
  3. The current commodity-induced profits recession may be short lived, but the real secular trend growth rate in EPS should be much slower than the past quarter-century.

Earnings per share for the S&P 500 Index peaked in the third quarter of 2014. The dramatic plunge in the prices of oil and industrial commodities as a result of slowing demand from China together with increased supply from the United States, decimated energy and materials companies' profits. In the years ahead, oil production will decline to remove excess capacity, prices will again rise above costs, energy company margins will recover, and market-level earnings will return to a normal rate of growth.

The future secular real rate of growth in corporate profits is far more important than the current commodity cycle to investors' long-term real wealth accumulation. During the past quarter-century, politically facilitated globalization allowed profits to grow much faster than per capita GDP, wages, and productivity, propelling capital's share of income to an unsustainable extreme.

The distribution of the economic pie is ultimately a political choice. With populist frustration increasingly pressuring policy change around the world, investors should expect labor, tax, and interest expense to rise faster than sales, thereby depressing profit margins and slowing real growth in earnings per share over the decades ahead.

Trouble In China

The past year, 2015, was turbulent for investors in most of the world's financial markets. The messy and opaque transition in China, from subsidized over-investment by state-owned enterprises toward a more balanced economy led by domestic consumption, generated financial turmoil. This slowdown in growth was accompanied by a decline in China's exports, capital outflows, downward pressure on the Chinese yuan, and dizzying (and market-halting) drops in Chinese equity prices.

The financial losses were not contained within China. Commodity prices continued their downward spiral, resulting from the surprise contraction in Chinese demand, following years of heavy investment and innovation to increase the supply of energy and industrial commodities. Resource- dependent emerging market currencies and equities plummeted in response.

Also in 2015, divergence in monetary policies unsettled developed currency markets: the European Central Bank and the Bank of Japan continued quantitative easing programs while the Federal Reserve rhetorically led markets on a long, slow walk to the first increase in the fed funds rate since the global financial crisis.

Shrugging off these global troubles, investors priced the U.S. equity market at year-end not far from where they had priced it at the beginning of the year. Beneath this seemingly calm aggregate market movement was growing distress in the energy and resource sectors. Perhaps even more notable, aggregate earnings peaked and began to decline. Although final full-year earnings for 2015 will not be reported for a few more months, market-level profits are obviously past their peak. Now, in January 2016, investors seem to be recognizing that U.S. corporate profits have rolled over. In this article we take a careful look at U.S. market earnings per share (EPS).


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