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U.S equity markets are priced for a sharp recovery in profit growth that at least one leading indicator suggests is unlikely to happen. The end result is a notable increase in portfolio risk, as a continuation in sluggish earnings growth would likely result in a significant market correction.

Morgan Stanley U.S. equity strategist Michael Wilson successfully predicted the slow profit growth we’ve seen in 2019 – 2.8 per cent year-over-year for the first quarter and 1 per cent for the second quarter.

In a research report earlier this week, Mr. Wilson reiterated his belief that an American profit recession has already begun. He noted that fourth quarter 2019 and full-year 2020 estimates “still look way too high” and far above even the overly optimistic forecasts that are typical from Wall Street ahead of a quarterly earnings season. The operative leverage assumptions based into earnings estimates – the ability of a company to translate slowing economic and revenue growth into higher profits – “seems fantastical to me," he wrote.

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The first accompanying chart shows year-over-year profit growth for the S&P 500 and the analyst consensus forecasts for coming quarters. The analyst community has already given up most of the optimism for third-quarter results, predicting a decline of 2.6 per cent.

So far, expectations for fourth-quarter earnings and full-year 2020 remain bullish at 4.5 per cent and 11.3 per cent, respectively. These are the guesses that Mr. Wilson finds overly optimistic.

Strategists such as Brian Belski, chief investment strategist at BMO Nesbitt Burns, have frequently emphasized the importance of the Manufacturing Purchasing Managers’ Index (PMI) from the Institute for Supply Management as a leading indicator for profit growth on both sides of the border. That relationship is highlighted in the second accompanying chart.

The PMI is a compilation of survey results from prominent U.S. manufacturing companies. Each respondent answers a series of questions each month regarding hiring, business activity and orders for new goods. The index is structured so that a reading of 50 means no change from the previous month, and levels above 50 indicate increased production.

Changes in the PMI have frequently provided indications on future profit growth during the postcrisis market rally. The clearest illustration of this is the period from January, 2016, to August, 2018, when improvements in manufacturing were followed quickly by rising profit growth.

Recent signs, however, have been much less positive. On Sept. 3, the manufacturing PMI for August was reported at 49.1. The sub-50 indicates the first contraction in month-over-month U.S. manufacturing activity since 2016.

The trend on the chart, with profit growth following the lead of the PMI, implies that U.S. earnings growth is headed lower, and there’s no hint yet of the recovery in profit growth that analysts expect.

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The last data point on the first chart shows that Wall Street currently expects 2020 earnings growth of 11.3 per cent year-over-year, or $18.60 per S&P 500 share. With the S&P 500 trading at about 2,980, this means the U.S. equity market is trading at 16.2 times 2020 earnings – expensive, but reasonable in light of ultralow bond yields.

If earnings start to disappoint, however, the S&P 500 will start looking expensive. In a hypothetical case where 2020 profit growth was 5 per cent instead of the 11.3 per cent expected, the benchmark is trading at a less palatable 17.2 times 2020 profits.

The PMI and the market’s growth backdrop could still improve so it’s not yet time for investor panic. Negative profit growth for the third quarter is already expected and, one hopes, already factored into stock prices. Investors should, on the other hand, pay close attention to any reductions in the fourth quarter and 2020 profit expectations as a sign that U.S. stocks may be headed lower.

Danger ahead: Skepticism over

profit-growth recovery

S&P 500, year-over-year profit growth

30%

25

20

15

Estimates

10

5

0

-5

Q1

Q1

Q1

2020

2017

2018

2019

S&P 500: 12-month EPS

YoY % chg.

ISM U.S.

Manufacturing PMI

63

35%

61

59

25

57

55

15

53

5

51

49

-5

47

-15

45

‘10

2012

2014

2016

2018

the globe and mail, Source: scott barlow;

bloomberg; Yardeni Research

Danger ahead: Skepticism over

profit-growth recovery

S&P 500, year-over-year profit growth

30%

25

20

15

10

5

0

-5

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3e

Q4e

2020e

2017

2018

2019

S&P 500: 12-month EPS

YoY % chg.

ISM U.S.

Manufacturing PMI

63

35%

61

59

25

57

55

15

53

5

51

49

-5

47

-15

45

‘10

2012

2014

2016

2018

the globe and mail, Source: scott barlow;

bloomberg; Yardeni Research

Danger ahead: Skepticism over profit-growth recovery

S&P 500, year-over-year profit growth

30%

25

20

15

10

5

0

-5

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3e

Q4e

2020e

2017

2018

2019

S&P 500: 12-month EPS YoY % chg.

ISM U.S. Manufacturing PMI

63

35%

61

59

25

57

55

15

53

5

51

49

-5

47

-15

45

‘10

2011

2012

2013

2014

2015

2016

2017

2018

2019

the globe and mail, Source: scott barlow; bloomberg; Yardeni Research

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