S&P 500 net margins bounce back, helping fourth quarter S&P 500 EPS exceed the peak in 2019
The S&P 500’s net profit margin certainly remained cyclical, it declined sharply in all past recessions and this pandemic induced recession was no exception. But this time the net margin rebounded in just a couple of quarters after the recession ended, whereas it usually takes three or more years for margins to recover to prior late-cycle highs. The S&P 500 non generally accepted accounting principles (non-GAAP) net margin declined from a peak of 12.2% in the second quarter of 2018 to 9% in the second quarter of 2020 and then bounced back to 11.9% in the fourth quarter of 2020. This quick rebound with 1.2% year-over-year revenue growth, helped put fourth quarter 2020 S&P 500 earnings per share (EPS) at new highs, despite zero profit at energy and industrial earnings still 1/3rd below the fourth quarter 2019 level. The main driver of this extraordinary margin bounce back was the S&P 500's shift in revenue toward the high margin tech sector, which reached its own record margin of 24%.
By sector, 7 of 11 made new non-GAAP net profit margin record highs in the third quarter or fourth quarter of 2020: tech, health care, communication services, consumer staples, utilities, financials and materials. The first five sectors are the group we have referred to as the young & healthy in this pandemic, which have either been largely immune or net beneficiaries. Materials and financials fourth-quarter margins and EPS were also up year-over-year as capital markets did well and big loan loss reserve releases boosted bank net margins.
R.I.P. margin mean reversion: S&P 500 margins are cyclical, but not mean reverting
While we are uncertain about the exact long-term sustainable net margin of the S&P 500, our long held view is that S&P 500 net margin expansion since the mid-1990s, through multiple cycles, is for structural reasons. The most significant two being tech and taxes. The growth of S&P 500 high margin technology and digital businesses both in the United States and abroad boosted index margins. The S&P 500’s effective tax rate fell as its foreign profits doubled since the mid-1990s, as foreign tax rates are lower, then the U.S. corporate tax rate cut in 2018. Deleveraging and lower interest rates also added a smaller boost to net profit margins over the decades. Thus, while the outlook for net margins will partially depend on U.S. and foreign tax rates and debt usage and interest rates (more debt tends to reduce net margins, but boost earnings per share), it's the mix of S&P 500 total revenue by sector most likely to determine net margins. Given index composition today and as we expect it in the future, we think S&P 500 net margins likely stay over 10% outside of recessions for the long-term.
It is important to realize that despite S&P 500 net margins rising since the mid-1990s that its return on equity is in-line with mid to late 1990s levels in the high teens. Competitive theory supports return on capital reversion to the cost of capital, especially for incremental capital additions, but not necessarily profit margin mean reversion. Most digital businesses have enormous tangible and intangible capital bases, which means their often very high margins do not always bring unusually high return on capital. For intangible asset oriented businesses, it is difficult to measure the economic capital base in place, especially the value of being the surviving innovator. But for physical asset-oriented businesses or highly competitive mature businesses, we think today's low interest rates will bring some pressure on profits and return on capital over time owing to lower prevailing capital costs than history.
Where is the U.S. dollar heading? Weighing GDP vs. real-interest-rate differentials
Dollar weakness in recent months on post recovery inflation concerns is being met with stronger dollar arguments based on a quicker economic recovery in the United States than Europe. Big fiscal stimulus in the United States has moderate medium-term inflation risk, but is probably worth the better chance of robust early cycle growth. However, we doubt U.S. growth or inflation will be high enough for the Fed to hike rates in 2022 and probably not in 2023. Hence, it seems too soon and unsure for the dollar to be seen as a better real interest rate earning currency than euro or yen despite stronger U.S. gross-domestic-product (GDP) growth. Without a superior real interest rate on the horizon, we are not sure if the dollar should appreciate much vs. euro, absent a flight to safety. If U.S. inflation jumps on too large or misdirected stimulus, the euro could rise. If Europe slips into a decade of no growth, the euro could weaken. Our S&P 500 EPS estimates assume the euro is 1.15-1.20 dollars in 2021 and closer to 1.15 dollars in 2022.
CIO Day: raise 2021E S&P 500 EPS to 175 dollars from 170 dollars, 2022E to 191 dollars from 185 dollars
We raise our 2021E (estimate) & 2022E S&P 500 EPS and boost our normalized 2021 S&P 500 EPS estimate from 178 dollars to 183 dollars. The increase in our EPS estimates is 2 dollars at tech / communications, 2 dollars at financials, 1 dollar at health care. We estimate S&P 500 fair value based on normalized EPS and assign a trailing price-to-earnings ratio (P/E) of 22, which assumes long-term real interest rates rise to 0% eventually. We expect the S&P 500 to reach 4,100 at March end 2022 and 4,200 at 2022 end.