In the past year, corporate profits in the United States can’t be described as brilliant, and the latest data is no exception
In the third quarter of this year, the domestic profits of American companies increased by only 1.3% compared with the previous quarter; if compared with the same period last year, they had fallen by 1.9%. The reason behind the contraction of domestic earnings of American companies is due to uncertain factors in international trade and the weak outlook caused by rising US wages (see chart).
In the short term, both of these factors are likely to intensify, as the ISM Manufacturing Purchasing Managers Index (PMI) is becoming weaker and the labor market is becoming tighter.
However, on the one hand, corporate profits in the United States have slowed, and on the other hand, the stock market is booming. It is nothing new. In fact, I believe there are 3 reasons why this situation can continue.
Falling borrowing costs offset falling returns on capital
(1) American companies may not have achieved strong profit growth, but they have not been under great pressure. The after-tax return on capital for U.S. companies has only fallen slightly from 4.9% earlier this year to 4.6% today.
On the other hand, the long-term and short-term borrowing costs also fell by 116 pips (e.g. 100 pips) and 66 pips, respectively, both of which fell even more. Therefore, based on the difference between the return on capital and the cost of borrowing, the investment of American companies is still profitable.
One strong piece of evidence for this optimistic outlook is that American companies continue to add new positions and hire staff despite signs of margins being somewhat less stressed.
Falling risk premium helps valuations rise
(2) The reason why the US stock market can rebound this year is largely based on multiple expansions. I think the reason that this situation can last until 2020 is that although US stocks are already overpriced relative to cash, they are still cheap compared to bonds. Compared with the past spreads of U.S. stocks and U.S. Treasuries, U.S. stocks have not risen too much.
Another positive factor is the decline in US debt default rates and liquidity risks. This can be seen in the narrowing of the US Swap Spread and the decrease in the stock market’s volatility index.
This part of the story explains why the US stock market’s volatility index (VIX) has fallen to its lowest level in more than a year. A low volatility index means that the stock’s risk premium is also reduced. Therefore, there may be a virtuous cycle of rising US valuations in the future.
Real estate recovery spurs manufacturing recovery
(3) Although some indexes show some signs of a slowdown in production activity in the near future, in fact, US producers may increase production soon. Inventory-to-sales ratios of US companies have stabilized and are beginning to decline.
The recovery of the real estate industry will also stimulate more production activities, because 60% of the industrial output value in the United States comes from the construction industry and the related consumer economy. The macro figures cannot reflect the operation of different economic sectors at all. The stock market cannot be said that the same economic figure will affect all sectors.
In fact, this year’s economic outlook is bleak, and semiconductor stocks, which are extremely sensitive to economic growth, have become stronger.
Also, in recent months, I mentioned in the online column that funds are converted between value and dynamic stocks. It is paradoxical that some cyclical stocks now belong to the category of value stocks. Therefore, buying of cyclical stocks is not only subject to economic outlook In addition to the impact, it will also be affected by changes in investor investment trends. In short, market fluctuations are affected by many factors. Simple analysis is easy to hear, but not necessarily useful.
Product expenses. This information can be seen from the recent improvement in the performance of some cyclical and defensive US stocks. Therefore, next year we should see some recovery in the US manufacturing industry.
For investors, the biggest risk of optimism in the US stock market is the sharp rise in inflation in the United States. This is always possible, and oil prices have risen to the higher end of their short-term trading range.
However, the biggest possibility is still due to wage-driven effects, and consumer prices are only gradually increasing.
Unless US inflation really rises above the 2% target, the liquidity provided by the US Federal Reserve to financial activities should remain abundant. For this reason, I think there is no reason why the U.S. stock market cannot make new highs in 2020.