One wouldn’t necessarily realize it by watching the market tick-by-tick in August, but there are several cracks starting to emerge in corporate America that could hint at a more muted finish to the year for equities.
But first, the good.
Last Friday marked the 44th record high for the S&P 500 (^GSPC) as investors viewed favorably a much better than expected July jobs report. Meanwhile, second quarter earnings season continues to impress with some eye-popping growth rates for corporate sales and profits.
Roughly 87% of S&P 500 companies have reported a positive EPS (earnings per share) surprise for the second quarter, according to FactSet. If 87% is the final percentage, it will represent the highest percentage of S&P 500 companies reporting better than expected earnings since 2008.
Earnings growth rates for S&P 500 companies have averaged 88.8%, tracking at the fastest clip since the fourth quarter of 2009, per FactSet analysis.
Now, about those red flags — or cracks in the market’s armor — which come compliments of closely watched Bank of America strategist Savita Subramanian.
First, mentions of inflation on corporate earnings calls has continued to accelerate. Thus far in the second quarter reporting season, inflation mentions have surged 1,100% year-over-year. Labor inflation is being mentioned the most, followed by supply chain inflation, as companies scramble to find workers and raw materials to service an economy recovering fast from the pandemic.
The first quarter growth rate in inflation mentions tallied 900% year-over-year.
Such a sequential acceleration in inflation mentions by executives suggest it will remain an issue well into 2022 and likely a headwind to profit growth.
And that brings us to red flag number two: weakening profit margin outlooks.
Subramanian notes consensus margin expectations for the second half will moderate and expects net margins to reach 12.6% in the third quarter (it hit 13% in the second quarter) and 12.5% in the fourth quarter.
“If cost pressure continues to accelerate, we could see more downside risk in second half margins,” warns Subramanian.
Amid that gloomier outlook for profit margins, corporate sentiment appears to be peaking — our red flag number three here.
Subramanian’s analysis shows companies’ mentions of business conditions indicate weaker business conditions versus the peak level of the first quarter. Mentions of optimism has also declined from the peak levels reached in the first and second quarters.
Put all of these red flags together, and it’s not a shock to see BofA modeling for the S&P 500 to finish the year at 3,800 — or a 14% drop from current levels.