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3 Reasons S&P 500 Profits May Stall

Mar 12, 2024

Investors banking on companies’ ability to grow operating margins may be disappointed.

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • Equities are surging on expectations that a robust economy will lead to corporate profit growth.
  • However, companies reported disappointing fourth-quarter operating margins, and analysts are revising down their profit forecasts for this quarter.
  • Meanwhile, signals from other markets suggest a scenario of slowing growth and persistent inflation.
  • Investors are advised to seek value in U.S. equities and balance portfolio exposure with quality growth investments in sectors such as energy, utilities, materials, financials and health care.

Stock prices have continued to surge, as investors expect a robust economy to translate into growth in companies’ revenues and earnings. Current estimates of 2025 earnings for S&P 500 Index companies are between $272 and $277 per share—a 25% jump from 2023 levels. At the heart of these optimistic forecasts is investors’ belief that companies’ operating-profit margins will expand. 

 

“Operating margin” measures how much profit a company makes on each dollar of sales after paying for the costs of production, such as materials and wages, but before paying interest and taxes. Investors seem to be banking on companies’ ability to grow this metric, but that’s a hypothesis we continue to approach with caution. Here are three key reasons.

  1. 1
    Companies reported disappointing margins in the fourth quarter of 2023.

    S&P 500 companies, excluding the mega-cap “Magnificent 7” tech stocks, actually saw their operating margins decline last quarter. What’s more, the share of companies reporting higher margins than analysts expected was only about 44%—among the lowest in two years. Such challenges came despite several factors that should have helped boost companies’ profitability, such as falling manufacturing costs and a strong U.S. dollar, not to mention labor costs that grew by half the estimated pace and economic productivity that rose a solid 3.2%.  

  2. 2
    Analysts are lowering their profit forecasts.

    Since the first quarter of 2024 began, analysts have continued to revise down their earnings estimates. As of January, expectations for the quarter’s year-over-year earnings growth were 6.5% for the S&P 500 overall, and just 2.8% for the index if we leave out the Magnificent 7. Those numbers have faded now to 4.3% and -0.65%, respectively.

  3. 3
    Growth may not prove as robust as equity investors think.

    Although equity markets appear to expect healthy economic growth that drives margin expansion, the markets for other asset classes seem to anticipate a different outcome. One-year inflation swaps (i.e., contracts that transfer inflation risk from one party to another) have risen to above 2.5%, suggesting some investors expect resurgent inflation. Gold is setting new record highs, while the U.S. dollar is weakening, implying that some investors may be seeking to hedge inflation amid potential economic weakness. Such positioning suggests a “stagflation” scenario in which the economy could stall while inflation persists, especially if labor markets stay tight. 

Learning from the Past

History suggests that generating sustainable changes in operating margins is very difficult. Case in point: At the turn of the century, the transformative wonders of the internet seemed to hold immense potential to bolster company profitability—yet S&P 500 operating margins remained in a very tight range of 9.5%-10.5% for most of the time between 2000 and 2016.

 

In more recent years, the growing margins of mega-cap tech stocks have in turn caused the S&P 500’s average margin to expand. While many market participants seem to expect this trend to continue, we would caution that the recent surge in productivity and margin growth may only be temporary.

How to Invest

In this environment, investors may want to seek out value in U.S. equities. Also consider balancing passive portfolio exposure to market-capitalization-weighted indices with quality growth investments in sectors such as energy, utilities, materials, financials and health care.

 

These areas present opportunities to hedge against excessive exuberance in the market while providing exposure to long-term growth themes beyond popular tech stocks.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 11, 2024, “So, About That Margin Expansion.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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Index Definitions

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Physical precious metals are non-regulated products. Precious metals are speculative investments, which may experience short-term and long-term price volatility. The value of precious metals investments may fluctuate and may appreciate or decline, depending on market conditions. If sold in a declining market, the price you receive may be less than your original investment. Unlike bonds and stocks, precious metals do not make interest or dividend payments. Therefore, precious metals may not be appropriate for investors who require current income. Precious metals are commodities that should be safely stored, which may impose additional costs on the investor. The Securities Investor Protection Corporation (“SIPC”) provides certain protection for customers’ cash and securities in the event of a brokerage firm’s bankruptcy, other financial difficulties, or if customers’ assets are missing. SIPC insurance does not apply to precious metals or other commodities.

Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets and frontier markets, since these countries may have relatively unstable governments and less established markets and economies.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Investing in small- to medium-sized companies entails special risks, such as limited product lines, markets and financial resources, and greater volatility than securities of larger, more established companies.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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