Wall Street’s most famous bear still isn’t buying it. Figuratively or, one assumes, literally.
“At current valuation levels, the equity market appears to be discounting the rate cuts that are priced into the bond market but without the growth risk,” Morgan Stanley’s Mike Wilson said Monday.
Wilson, who enjoyed a remarkable run of forecasting success in 2022, has insisted this year that earnings expectations are too rosy and that eventually, stocks will be forced to reckon with profit deterioration born of negative operating leverage.
It now seems reasonably clear that Q1 earnings season will pass without incident. More than three-quarters of S&P 500 companies beat estimates, the most since Q3 2021. All “low bar” criticism aside, it just wasn’t that bad.
And yet, as Wilson pointed out Monday, there’s ample evidence that the economy is slowing, and if you believe bank failures presage tighter lending standards down the road, it’s not difficult to make the case that between constrained credit and the drag from 500bps of Fed tightening, growth will remain below-trend, at best. Eventually, one assumes, consumers will tire, and corporate pricing power will wane accordingly.
In the meantime, earnings revisions breadth is taking a glass half-full view. The improvement on that front stands in stark contrast to “much of the leading macro data,” Wilson wrote, flagging a gauge of cyclical GDP components and a standardized aggregate of the regional Fed surveys, both of which are consistent with recession (as shown in the figures above).
As discussed at some length in the latest weekly+, the equity market is very, very narrow. Recent outperformance from the largest stocks led to a steep drop in market breadth, which Goldman’s David Kostin noted has “contracted to one standard deviation below average for the first time since 2020.”
On Monday, Wilson underscored the point. The equal-weighted S&P’s recent underperformance remains a sight to behold. Note in the visual below the veritable collapse in 2023.
“We continue to believe that if this were the start of a new bull market, breadth measures would be showing significant signs of improvement,” Wilson wrote, reiterating talking points from last week’s note, and again pointing to a yawning disconnect between the Nasdaq Composite and its cumulative advance/decline line.
He also mentioned another factoid which I highlighted last week — the median S&P stock trades at a higher multiple than the index. As Wilson put it, “the valuation excess is not just in the mega-cap stocks.”
That’ll sound familiar to regular readers. Early last month, I called it “the worst of both worlds,” as it suggests the equity market is narrow but also broadly expensive.
Ultimately, Wilson remains concerned that stocks are mispriced given myriad risk factors. “Our fair value risk premium framework suggests the equity market is discounting an ISM Composite reading in the 60s [and] our industry group performance versus ISM analysis suggests that every S&P industry group with a significant correlation to the PMI is priced for a higher reading than where the indicator is today,” he wrote. “Thus, equities are priced for an optimistic policy and growth backdrop, implicitly creating a high bar in terms of developments on both fronts.”
Mr. Wilson is one of one of the few analysts who seems to pay any real attention to the impact of operating leverage. This effect is probably the most critical single driver of corporate profits, strategies and industrial structure in general. Most folks know that business costs come in two flavors, fixed and variable. Fixed costs are related to capacity and rise or fall only when capacity changes. Variable costs are proportionally related to sales. Gross margins (essentially sales – var costs) remain proportionally constant as a percent of revenues. The higher the proportion a firm’s fixed costs are as a proportion of the total, the higher the leverage and the profit magnification it creates, either up or down. Some firms can’t do much about this structure internally but in the wilds of corporate accounting, outsourcing and globalization strategies can completely change the operating leverage. A company that makes its own stuff absorbs all its fixed cost and sees a boost in leverage, and a rising magnification of profits during periods of revenue growth (or as Mr. Wilson points out, declines which are magnified during revenue declines). However, if another firm makes one’s stuff and sells it as whole goods (i-phone cameras, batteries, chips, etc, that turns the costs paid entirely into variable costs, which create no leverage. Even when a firm buys some or all of its whole goods from others and total costs don’t change, this outsourcing strategy reduces operating risk, which falls to the contractor. It is the cost structure here that is critical and skillful managers can use this idea to fine tune profit growth and the risk of leverage. However, those risks can get a hairy ride. Integrated firms that make their own parts and products, take an operating leverage beating in bad times but enhance control over their in-house supply chains. Firms that outsource those tasks reduce the leverage risk, but may lose control of their supply chains. This is the main reason I say operating leverage, and how firms have to deal with it, is a key strategic/profit driver in most of our significant industries.
Incidentally, one group of individuals which largely ignores the critical effect of operating leverage is the bone throwers (economists). They talk about marginal cost and marginal revenues, but not marginal profits and operating leverage.
Dr Lucky – Thanks. That is a great primer and reminder of the lure of outsourcing everything, like so many tech firms over the past 15 years.
+1
I suspect that “gross margin” in company financials is not even the same as “gross margin” in economist-speak.
Bottoms=up sellside estimates, also, usually underestimate operating leverage, in part because they under-model and under-estimate the impact of the fixed portion of cost of goods sold on gross margins.
Most companies report depreciation, which is largely fixed, in COGS. Manufacturing and warehousing/distribution usually have significant fixed components as well. Then there is accrual accounting, wherein revenue recognized today carries cost of goods from when the inputs were acquired and assembled.
I have found it useful to track incremental gross margin = (gross profit period n – gross profit period n-1) / (revenue period n – revenue period n-1) and incremental operating margin. This helps identify companies with higher or lower operating leverage, and provides a reality check as to how margins should respond to change in revenue.
A strategist (Wilson?) has a team able to aggregate the historical incremental margins for every stock in the index and get a pretty decent sense for how much margins should fall (rise) as revenue falls (rises).
There’s a whole crowd of bearish strategists lamenting the fact the market is refusing to cooperate with the profit margin compression/recession playbook. Wilson’s data selection & confirmation bias may have led him to underestimate the willingness of consumers to pay increasingly exorbitant prices, allowing many consumer staples companies to protect margins (“Greedflation” as you have covered here), He also ignores the labor market strength in his analysis, which may render some of the historical comparisons less relevant.
Speaking for myself, I would prefer an analysis which acknowledges the current context while considering past relationships. Those of us who remember the late 70’s & early 80’s inflation experience recall the dim view taken of most interest rate and economic forecasts by the end of that era.