The stock market has surged to an expensive level, making it vulnerable to risks, and the next big challenge is likely to emerge when companies report third quarter earnings results.
The S&P 500 has gained about 21% from its bear market low hit in early October. It now trades at almost 19 times earnings per share estimates for the next year, up from just below 16 times at the October low.
The...
Nike is another example of a company trying to reduce inventories.
Scott Olson/Getty Images
The stock market has surged to an expensive level, making it vulnerable to risks, and the next big challenge is likely to emerge when companies report third quarter earnings results.
The S&P 500 has gained about 21% from its bear market low hit in early October. It now trades at almost 19 times earnings per share estimates for the next year, up from just below 16 times at the October low.
The market is anticipating earnings to grow next year off this year’s lower base—the idea being the Federal Reserve will refrain from lifting interest rates further, allowing for some economic growth and some lower inflation.
But the risk is company sales and profits will get hit before they recover. While inflation has dropped to around 4% year over year most recently from a peak of over 9% last year, economic growth more broadly has dropped, too.
That may be reflected in third quarter earnings, with companies carrying too much inventory. U.S. companies have seen their aggregate inventory-to-sales ratio rise about 10% to about 1.4 from around 1.27 at a low point at the end of 2021, according to St. Louis Fed data. With more supply of goods, companies might have to limit price increases, and because they can’t slash all costs, their profit margins could suffer. Lower sales growth plus falling margins means considerable pressure on bottom line figures.
“Bloated inventories across the economy will now lead to the order cancellations and price discounting that change the trajectory of revenue growth expectations provided by company guidance,” wrote Morgan Stanley ’s chief U.S. equity strategist Mike Wilson, who also warned that margins will come under pressure.
The risk can be seen through the producer price index. This year, companies such as Generac (ticker: GNRC), which makes power generators for homes and businesses, are trying to reduce inventory. That means the Generacs of the world aren’t clamoring to acquire supplies the way they did during last year and 2021.
Less demand for inputs lowers the PPI, the growth rate of which has declined recently. There is a strong correlation between the PPI and S&P 500 sales, and given where the PPI has recently gone, S&P 500 sales excluding financial companies should decline year over year, according to Morgan Stanley. That would be a disappointment considering analyst aggregate expectations for the index of 2% sales growth this year.
Nike’s quarter, which the company will report on June 29, will have a “particular focus on sales growth and gross margin recapture,” wrote Telsey Advisory Group analyst Cristina Fernandez, who said the company’s ongoing inventory clean-out could take a few quarters in total.
Maybe just a few more hiccups for this market, which is trying to dig itself out of its hole.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com