The tightening squeeze on corporate profits is the biggest risk to the stock market right now

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A seemingly modest decline in profit margins can transform strong sales growth into flat or even declining earnings — and pose a major threat to the U.S. stock market, MktwHulbert writes.

You may not appreciate this threat. It’s easy to focus instead on the continued and surprising strength of economic demand, which has translated into a robust growth rate of corporate sales over the last year. But a seemingly modest decline in profit margins can transform strong sales growth into flat or even declining earnings.

Yet the market over the long term would struggle even if the S&P 500’s profit margin were to remain at its currently still-elevated level. With a constant margin, future stock market growth can come from just two sources: revenue growth and/or P/E expansion. Marginal outlook The prospect of a static S&P 500 profit margin in coming years is sobering enough. But, unfortunately margins are likely to face downward pressure in coming years, according to a report from two analysts at Ned Davis Research: Ed Clissold and Thanh Nguyen .

High inflation could prove to be short-lived this time around, of course. But, in another recent report, Clissold and Nguyen point out that low inflation could also squeeze profit margins over the short term: “For much of the [coronavirus] pandemic, inflation has been rising faster than wages, meaning that in aggregate companies have been able to pass higher costs to customers.

 

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