Earlier we explained why Goldman believes that in 2016 the market, which is now about 1% higher than where it closed in 2014, will also go exactly nowhere.
The reason for this pessimism can be summarized in three bullet points:
i) bifurcated thematic returns. Goldman thinks that due to divergent monetary policies (Fed tightening vs. ECB and BoJ easing) the USD will strengthen and benefit some stocks and harm others. Some of those impacted the most will be multi-nationals and luxury retail companies (see Tiffany earnings today). Overall, the biggest headwind cited by companies in Q3 has been the strong dollar - expect this to continue and to further depress revenues, and thus earnings.
ii) higher rates. According to Goldman, "when fund managers eventually realize the tightening process will be more sustained than originally anticipated the P/E multiple will contract and offset the otherwise positive impact of 10% earnings growth."
iii) margin expansion stories. If companies can't rely on top line growth, and multiple expansion is not available, there is just one source of growth: margin expansion.
It is bullet iii) that is the most important, because here the divergence between Wall Street's hopium-driven margin euphoria is most visible.
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According to Goldman, "tech accounted for 50% of the overall S&P 500 expansion during the past five years (Apple is responsible for 20% of rise). Tech sector now has margins (18%) that are twice the overall market."
That tremendous tech, but mostly AAPL-driven, margin growth has now ended.
So can this torrid surge in tech margins continue? Goldman's answer is a resounding no.
Many of the drivers of margin expansion during the past few decades appear to be behind us including lower interest rates, outsourcing, and technology. S&P 500 net margins have been essentially flat for five years at just below 9%. We forecast margins will remain flat in 2016 and 2017 at 9.1%. Information Technology has been a notable exception with margins rising in recent years to 18%, or 2x the overall market. However, roughly 40% of the 847 bp leap in Tech margins since 2009 is attributable to Apple (AAPL) alone. Given rising labor and health care costs, firms in most industries will struggle to simply maintain margins. Investors will reward firms able to demonstrate a path to higher sales and margins.
But perhaps the one chart that confirms that one can't have their wage rising cake and eat corporate profits too is the following:
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In other words, if the Fed is hiking "because it sees something about the economy" that few others do - i.e., rising wages - then by definition that means that profit margins will contract as growing wages take out ever bigger chunks of the corporate bottom line.
So with sales declines set posied to accelerate due to the soaring dollar, central bank liquidity-driven multiple expansion no longer feasible and corporate margin growth set to resume its contractionary path again, we wonder where will the next leg higher in stocks come from. Unless, of course, the whole "the Fed is hiking because the S&P500 has topped out economy is recovering" was just the latest economist consensus mirage.
