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For students of stock market disasters, this is where things get interesting.

Up until now, the crash has been largely predictable – a simple but painful demonstration of what happens when inflated stock prices run into the buzz saw of rising interest rates.

On Friday, that combination briefly dragged the S&P 500 benchmark index of large U.S. stocks into bear-market territory, meaning at least a 20-per-cent decline from its highs. The index recovered its losses and closed at 3,901.36, down about 19 per cent from its Jan. 3 close of 4,796.56.

But this simple story is now growing more complicated. What happens next will depend largely on whether companies can deliver the earnings that investors expect over the months to come.

If they can, the market carnage should be mostly over. If they can’t? Brace for more bloodshed ahead.

Strong earnings are crucial to the stock market, because share prices ultimately rest on only two pillars – how much companies earn and how much shareholders are willing to pay for a slice of those earnings.

The second pillar is not looking so sturdy these days, because discerning investors are growing stingier. They are less willing to pay through the nose for stocks, because rising bond yields over the past few weeks have made bonds an increasingly attractive alternative to owning equities. This pushes down price-to-earnings ratios – the key measure of how much investors are willing to pony up for a buck of corporate earnings.

Investors’ increasing reluctance to pay up for earnings means the first pillar – how much companies are actually generating in profit – becomes the key support for share prices.

The good news on this front is that Wall Street analysts see reasons for optimism. They continue to predict above-average sales growth and above-average profit margins for the rest of the year.

Now, granted, Wall Street analysts are occupationally inclined to cheeriness (apparently there’s not much money in peddling gloom). You should treat their projections about as seriously as you do preseason forecasts for the Toronto Blue Jays.

Still, if analysts’ projections are correct, fair value for the S&P 500 lies around 4,181, according to a recent calculation by Aswath Damodaran, a finance professor at New York University. That would imply a considerable bounce upward from the current level.

The problem is what happens if analysts’ happy expectations for earnings don’t pan out. Then things could get very, very interesting. It is easy to see the market slumping to 3,750 (Capital Economics’ forecast), 3,550 (Rosenberg Research’s call) or even lower.

There are at least four reasons to think an earnings slump is possible and even probable:

Trouble in stores: Both Walmart Inc. and Target Corp. fell seriously short of forecasts when they reported quarterly earnings this week. Their stock prices fell fast and hard.

Each of those iconic retailers faced specific challenges during the past three months, but their dismal earnings reports also reflected some common themes – rising wage costs, snarled supply chains and inflationary pressures. If these flagships of consumerdom are feeling pain from these issues now, it seems likely that other companies will experience similar twinges soon.

The pull of normality: If you look a chart of U.S. corporate profits over the past four decades, it’s hard to miss the epic explosion of profitability during the COVID-19 pandemic. Corporate earnings soared in 2020 and 2021, bursting past all recent precedent. (Canadian corporate profits enjoyed a similar boom.)

Corporate profits usually don’t rocket ahead like this, and for good reason. In normal times, if any business is enjoying big fat profit margins, rivals rush in and undercut them. Competition usually brings surging profitability back to earth.

The pandemic may have delayed this response, but unless something has fundamentally changed in the economy, competition is likely to reassert itself over the next couple of years, dragging profit margins back to more typical levels.

Going cold turkey on stimulus: Why did profits boom in the pandemic? The most obvious reason is the tsunami of government stimulus that washed over the economy, lifting all boats and filling all pockets.

As we all know, this stimulus largesse is being wound down. What most people don’t realize is just how dramatic the withdrawal is going to be.

In the United States, federal government spending accounted for more than 13 per cent of the economy in 2020 and 2021. This year it is forecast to fall back to under 5 per cent of gross domestic product, and then dwindle further to 3 per cent in 2023, according to the Congressional Budget Office.

That is an enormous shift in government spending, one equivalent to about 10 per cent of GDP disappearing between 2021 and 2023. (In Canada, federal spending is following a similar path, shifting from a deficit of 14.9 per cent of GDP in 2020-21 to a deficit of 4.6 per cent in 2021-22.)

The theory is that private-sector spending will seamlessly fill the gap left by lower government spending. Maybe so. Don’t count on it, though. If the transition isn’t quite as smooth as hoped, corporate profits could suffer.

Payday blues: For now, both Canada and the United States are enjoying booming job markets. This is undoubtedly a good thing. But it is also leading to increased demands for higher wages. As wages swell, profit margins are coming under pressure. (Just ask Walmart and Target.)

The coming squeeze on margins could be intense, especially in the U.S., where wage pressures are expanding quickly as workers demand bigger paycheques to keep up with runaway inflation. Wages for full-time U.S. workers are now galloping ahead at a pace of 6 per cent a year, according to April data from the Federal Reserve Bank of Atlanta. This is the fastest rate of increase in more than 20 years.

Meanwhile, unionization drives at Starbucks and Amazon are meeting with some success. While it’s still too early to speculate on the long-run success of the new labour movement, any resurgence in labour’s power could deliver a nasty blow to corporate profits, especially in the service sector.

Count rising wages and growing labour militancy as additional reasons to be wary of today’s stock market. Profits must show steady growth from already elevated levels to support stock prices. But as investors discovered this week, there are many reasons to doubt whether profits can deliver.

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