Two “Data” items today:
#1: A long-run correlation analysis between the US dollar and the S&P 500. We got to thinking about this topic last week, when we looked at both the direction of the dollar and (separately) the percentage of S&P 500 sector revenues that come from non-US sources. Today we’ll pull the two ideas together to answer the question “should US equity investors root for a weaker dollar (because that helps offshore earnings translation) or a stronger one (as a sign of the American economy’s strength)?”
The chart below shows the trailing 100-day correlations of daily returns for the S&P 500 and the Federal Reserve’s Trade Weighted Dollar index from 2006 – present. A few summary statistics:
- The average dollar/S&P 500 correlation over the last 15 years is -0.26, for an r-squared of just 6.8 percent.
- The standard deviation of this time series is 0.23 points, which means we can expect US large cap stocks and the dollar to trade in a band of essentially zero correlation to negative 0.50 (r-squared of 25 percent).
This data, therefore, clearly says that dollar-based US equity investors should not worry too much about the direction of the greenback. If I told you with perfect certainty that the dollar would be 5 percent weaker or stronger in a year’s time, the historical record says this would not help you predict where the S&P 500 would be in October 2022. Yes … You might guess “higher” for stocks if I told you the dollar would weaken, based on that negative 0.26 correlation mentioned above, but the standard deviation is so large that it would be unwise to stake too much on the outcome.
Also worth noting in the graph above: if the dollar and stocks do happen to move vaguely in the same direction over 100 days, all you know for sure is that it will not last long. Spikes to positive correlations occurred briefly in 2008, 2014, 2015, 2017 and 2018. Every time soon after, however, correlations returned to their modestly negative bias.
Takeaway: the direction of the dollar is a useful issue to consider in the context of fundamentals (e.g., corporate earnings, global investor sentiment, etc.), but on its own it is a poor predictor of US equity returns.
#2: We were struck by the following chart in FactSet’s latest weekly Earnings Insight report showing S&P 500 net profit margins from 2016 – present, including what analysts expect for Q3 2021. The calculation here is simply net income divided by revenues. Our annotations, in red, show the average net margin for 2017, 2018, 2019, and the most recent 4 quarters including the estimate for Q3 2021.
As you can see, the companies of the S&P 500 have been significantly over-earning over the last 4 quarters (all due to Q1 – Q3 2021), with an average profit margin of 12.3 percent, versus 2018’s 11.6 pct and 2019’s 11.3 pct. The step up from 2017 to 2018 was due to a lower corporate tax rate, but these have been stable since.
Which sectors are responsible for this structural improvement in S&P 500 margin structure? The short answer is “all of them, except Real Estate, Communication Services, and Consumer Discretionary”. This FactSet chart shows expected Q3 2021 net margins (dark blue) as compared to the 5-year average net margin for each sector (bright green). The only Q321 net margin that looks unsustainably high to us is Financials, since Q3 bank earnings are expected to benefit from lower-than-expected Pandemic Recession-related loan losses.
Where S&P 500 profit margins settle out is important for 2 reasons:
- Everything else equal, higher margins mean higher returns on capital and therefore higher valuations. The multiple on a stock where the company earns a sustainable 15 percent return on capital is higher than if that company only earns a 12 percent ROC. Higher returns mean stronger dividends, larger stock buybacks, potentially higher reinvestment rates on capital and a better backdrop for pursuing value-added M&A growth.
- With a corporate tax increase possibly looming, US companies will need to offset the effect of higher tax rates with better sustainable margins to keep their return on capital constant. Again, ROC is the bedrock of equity valuation; lower returns always mean lower valuations.
Takeaway: at current valuations, the S&P 500 is clearly trading as if the Pandemic Recession reset structural profit margins higher. Will inflation upend that? We don’t think so. Large companies have the systems in place to manage rising input costs and pass along price increases to hold (or even enhance) margins. And while we rarely see this mentioned, that is actually the best argument that current inflation will prove stickier than the Federal Reserve anticipates. American companies have operated in a disinflationary environment for decades. Now, they are seizing the opportunity to take pricing where they can. They may get used to that.