At my latest appearance on the Morning Show on Al Sharq News Bloomberg, last Sunday, I was asked for my opinion about corporate profits and stock market valuations. Although I do not usually like to comment too much on the stock market, because for us it is not an independent driver in our models, but rather the outcome of the macro fundamentals we analyse, it is difficult to ignore the gap that has recently opened between fundamentals and equity prices.
Corporate profits remain anchored in the macro economy. Over the long run they move with nominal GDP growth and productivity, adjusted for the cost of capital. This relationship has proven remarkably stable over decades, with the exception of the period between the mid-1980s and early 2000s, when globalization combined with an explosion of corporate debt temporarily allowed profits to run ahead of the macro backdrop. Today the model is not flashing red, but it does reflect a weakening environment. Growth is slowing, productivity improvements are modest, and interest rates remain elevated. None of this suggests a collapse, but it does imply that corporate profits will come under pressure.
It is important to stress that profits and valuations in this framework do not depend only on real growth and productivity. They can also rise if interest rates fall, or if inflation pushes nominal GDP growth higher. In other words, a policy mix of lower rates and tolerance for inflation above target is supportive for profits, provided real growth does not turn sharply negative or productivity plummets. This helps explain why markets sometimes appear resilient even in periods of weak real activity: nominal dynamics and financing costs can offset some of the underlying weakness.
Valuations, meanwhile, have continued to rise. The S&P 500’s price-to-earnings ratio sits well above what these fundamentals can justify. It is worth noting, however, that this index is the whole 500 and is biased upwards by the “Magnificent 7” mega-cap technology stocks. Their outsized weight has pulled aggregate valuations higher, masking the fact that much of the market trades on more modest multiples. Even so, the headline valuation is what drives sentiment. We can see from the chart below that the the YoY change in the overall market P/E ratio is turning negative again and is consistent with the underlying weakening macro fundamentals.
If the economy decelerates further and the ten-year rate remains at such elevated levels (mainly because of the Federal Reserve being behind the curve), price-to-earnings ratios will likely continue to correct amid a deceleration in corporate profits. The adjustment is a natural one: a market that has run too far ahead of what the economy can deliver tends to realign with fundamentals over time.
The message is straightforward. Fundamentals still matter, and they are pointing toward a period of weaker profits and lower valuations. Not a collapse, but a correction.
Regards,
Andre Chelhot, CFA
The Macro Anchor
can you estimate to what extent the S&P is driven by foreign investment?