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Few paid attention a couple of weeks ago when the government announced that corporate profitability had declined markedly last quarter.
Yet future historians may eventually look back and pinpoint that report as the beginning of the end of this aging bull market.
That's because the first-quarter's decrease could signal the long-awaited return to historically average profitability levels. If so, the stock market will have to struggle mightily just to keep its head above water over the next five years.
Here's the sobering data: According to the latest calculations of the U.S. Department of Commerce, corporate profits in the first quarter of this year represented 8.8% of gross domestic product. That's the lowest level in nearly four years, and represents a big drop from the 10%-plus profitability that prevailed in the last quarter of 2013.
Those who focus on corporate profitability have worried for some time that such a decline was imminent. That's because, in the past, profit margins have exhibited a strong tendency to "revert to the mean," according to James Montier, a member of the asset allocation team at Boston-based GMO. In other words, margins in the past have eventually declined whenever they rose significantly above their long-term average, and vice versa.
That long-term average is 6.3%, according to the government's data. Unless corporate profitability has reached some kind of permanently high plateau, the recent drop is just the beginning of a much bigger decline.
What would it mean for the stock market if profitability reverted to the historical mean?
To calculate the consequences of a reversion to mean of corporate profitability, we must first make a few assumptions, as follows:
Once we make these assumptions, calculating the stock market's return over the next five years becomes a matter of simple math. The picture isn't pretty: Its five-year return, annualized, is minus 2.8%.
If so, the S&P 500 (.SPX) in the summer of 2019 would be trading at 1,703.
In fact, given the data, coming up with a rosy outlook for the next five years isn't easy. If we assume that corporate profit margins stay constant, for example, then the stock market's future growth will be the same as economic growth. That's 4.1% annualized on a nominal basis, given my generous assumptions.
Even a return to the record levels of corporate profitability above 10% of GDP won't produce anything like historically average stock market returns over the next five years. The only way for that to happen is for corporate profits to take an even bigger share of GDP in the future.
While anything is possible, that seems unlikely, according to Robert Arnott, chairman of Research Affiliates. For that to happen, the share of national income going to workers would have to shrink. In that event, Arnott says, "the backlash could be so widespread that it would turn Occupy Wall Street into a mainstream event."