Corporate Profit Margins Are Finally Stabilizing, Creating New Tailwind for Stocks

More than halfway through the first-quarter earnings season, the net profit margin of companies in the S&P 500 has ticked up to 11.5% from 11.3% in the fourth quarter, based on actual results and estimates for companies that haven’t yet reported.

That would mark the first increase after six quarters of sequential declines and suggest that margins have potentially hit a bottom, according to John Butters, senior earnings analyst at FactSet. Net profit margins peaked at 13% in the second quarter of 2021 before beginning their descent.

Of course, it is too early to tell if cost pressures will abate over the longer term and corporate profits will start rising again. Companies across industries are still battling higher prices for key inputs such as labor, materials and energy, as well as rising borrowing costs stemming from the Federal Reserve’s aggressive interest-rate increases.

Still, the improvement in margins offers a consolation to investors who have been trying to assess the economy’s trajectory while the Fed continues raising interest rates. The S&P 500 is up 5.8% in 2023 but is essentially flat over the past month.

“You do still have some cost pressures from inflation as well as some uncertainty over how long consumers can continue their resilient spending, so we are advising clients at this time to be relatively more defensive," said Lisa Erickson, head of the public markets group at U.S. Bank Wealth Management.

Ms. Erickson said she recommends that investors hold fixed-income assets as well as stocks in the real estate and infrastructure industries for their steady dividend payments in an uncertain economic environment.

Corporate earnings have historically been one of the biggest drivers of stock gains, and the latest earnings season has generally shaped up to be better than feared. With results in hand from nearly 70% of the companies in the S&P 500, profits are projected to have fallen 2.9%. That is a marked improvement from analysts’ call for a 6.7% decline at quarter-end.

Many companies are still rushing to cut costs, with inflation remaining elevated despite easing from peak levels and wage gains picking up in the first quarter.

3M, for example, said last week that it would cut 6,000 more jobs, on top of the 2,500 positions it announced in January, to streamline its corporate operations, simplify its supply chain and reduce management layers. The maker of Scotch tape and Post-it Notes reported a 25% decline in earnings while also battling soft demand for its products. 3M shares are down 15% this year.

Similarly, Tyson Foods said last week that it would eliminate 15% of its senior leadership positions and 10% of its corporate roles. The largest U.S. meat supplier by sales has been under pressure as it grapples with higher costs across its business. Its stock is down 3.4% this year.

The Fed on Wednesday raised interest rates by an additional quarter-percentage point to a range between 5% and 5.25%, a 16-year high, while signaling it could be done lifting rates after that. The decision marked its 10th consecutive rate increase aimed at battling inflation in moves that took time to ripple through the economy.

Consumer spending and factory activity have slowed, while steady hiring and wage growth threaten to keep inflation elevated. Stress in the banking sector has made investors more anxious about the possibility of the economy slipping into a recession.

A recession is typically bad news for both the stock market and corporate earnings. The S&P 500 has declined a median of 24% in recessions going back to 1946, according to research from Deutsche Bank.

Meanwhile, earnings among companies in the S&P 500 have dropped 30% on average over the past 10 recessions going back to 1957, according to D.A. Davidson. Excluding the more- pronounced downturns that accompanied the bursting of the dot-com bubble in 2001 and the financial crisis of 2008-09, profits fell 19%.

This time could prove to be different, but that might not be enough to break stocks out of their lull.

Economists generally agree that they expect any recession this year to be relatively quick and shallow. On the earnings front, analysts expect profits to fall again in the current quarter, before they start climbing in the second half. For the calendar year, earnings are projected to inch up 1.2%.

Stocks still look expensive historically. The S&P 500 is trading at about 18 times its projected earnings over the next 12 months, higher than the 10-year average of 17.3, according to FactSet.

Investor sentiment remains bearish, which is typically a contrarian indicator for the market. The latest survey from the American Association of Individual Investors showed that 38.5% of investors are bearish about the direction of the stock market, above historical levels though improved from March.

“I think there’s some room for disappointment later in the year, but the bearish sentiment and high cash on the sidelines are two major factors and a ballast to equities," said Dylan Kremer, co-chief investment officer of Certuity, a multifamily office that manages more than $4 billion in assets.