Weekly Trends

Ryan Lewenza, CFA, CMT, Private Client Strategist

December 11, 2015

Peak Margins?

Equity Market YTD Returns (%)

One of the major debates occurring among analysts is whether the current
record profit margins are sustainable or are destined to fall. Currently, S&P 500
Index (S&P 500) net income margins are 10.6% versus the 15-year and 25-year
averages of 9.5% and 7.3%, respectively.

S&P/TSX Comp
S&P/TSX Small Cap

Currently the S&P 500 is trading at 18.7x trailing earnings, which is two multiple
points above the long-term average of 16.5x. Given the prospect of Fed
tightening and other potential risks to the economy/stock market, we expect
some P/E compression in 2016, and therefore are using a P/E target multiple of
17.5x. Multiplying our S&P 500 $123.96/share earnings estimate by our
projected 17.5x P/E multiple, we derive a year-end price target of 2,170. If
realized, this would equate to an 8% total return, including a 2% dividend yield.

This will be our last Weekly Trends publication for the year.
Our next publication will be our 2016 Market Outlook.

S&P 500
-4.6

MSCI World

-2.6

MSCI Europe

5.1

MSCI EAFE

-3.5

MSCI EM

-16.8
-25 -20 -15 -10

Canadian Sector

42%

Corp. Profits Before Tax As % Of GDP (LHS)

Wages & Salaries As % Of GDP INVERTED (RHS)

43%

12%
11%

44%

10%
9%

45%

8%
46%

7%

-5

TSX Weight Recommendation

7.1

Overweight

Consumer Staples

4.5

Market weight

Energy

18.3

Market weight

Financials

38.6

Market weight

Health Care

2.9

Market weight

Industrials

8.0

Overweight

Information Technology

3.1

Overweight

Materials

9.7

Underweight

Telecom

5.6

Overweight

Utilities

2.2

Underweight

Level

Reading

Technical Considerations
S&P/TSX Composite

13,032.9

50-DMA

13,533.8

Downtrend

200-DMA

14,342.1

Downtrend

34.0

Neutral

15,500
15,000

S&P/TSX
50-DMA
200-DMA

14,500
14,000
13,500
13,000
12,500
12,000

6%

47%

11,500

48%

11,000
Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15

5%
4%
'85

'90

'95

'00

'05

'10

Source: Bloomberg, Raymond James Ltd.

Please read domestic and foreign disclosure/risk information beginning on page 4

Raymond James Ltd. 5300-40 King St W. | Toronto ON Canada M5H 3Y2.
2200-925 West Georgia Street | Vancouver BC Canada V6C 3L2.

10

Consumer Discretionary

16,000

We Expect Higher US Wages Which Should Weigh On Profit Margins

13%

-0.2

RSI (14-day)

Chart of the Week

14%

-17.3

Russell 2000

Consensus estimates for 2016 signal further margin expansion to 11%. We

believe this is too high, and are modelling a slight margin compression of
roughly 40 bps to 10.25% as wages and higher interest expense negatively
impact margins.
Based on our 2016 macro forecasts of 2.3% US real GDP growth and 1.5%
inflation, we estimate that S&P 500 sales will grow by 4.5% in 2016. Applying our
10.25% net income margin estimate, and 1% for stock buybacks, we forecast
S&P 500 2016 earnings of $123.96/share, which equates to 5.9% Y/Y growth.

-10.9

Source: Bloomberg, Raymond James Ltd.

Weekly Trends

December 11, 2015 | Page 2 of 4

Peak Margins?
One of the major debates occurring among analysts is whether the record profit
margins (earnings dividend by sales) are sustainable or destined to fall. Currently,
S&P 500 net income margin is at 10.6% versus the 15-year and 25-year averages of
9.5% and 7.3%, respectively. The current narrative from the bearish camp is that
profit margins are mean-reverting, and therefore will peak soon, taking stocks lower
with them. Others believe that margins are driven by secular changes such as lower
interest rates, and higher efficiencies from technology. In this weeks publication we
examine the drivers of margins and provide our take on this hotly debated topic.
In forecasting margins we need to analyze the different component parts that go
into margins. These include:

S&P 500 Sales Are Strongly

Correlated With US GDP

Sales growth: It all begins with the top line, or revenues. S&P 500 sales are
driven by economic growth as illustrated in the accompanying chart (sidebar).
Based on our 2016 US real GDP growth estimate (2.3%), and inflation (1.5%), we
estimate that S&P 500 sales will rise 4.5% next year. Positive for 2016.

10%
5%

4%

0%
2%
-5%

0%
-2%
-4%

-10%

US GDP Y/Y (LHS)

S&P 500 Sales Y/Y (RHS)

-15%

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Selling, General & Administration: The next item is SG&A which captures
salaries and other expenses. Companies have been managing costs very well
since the last downturn, by cutting jobs and keeping wage growth low. However,
we believe this has largely been exhausted, and see wages rising as the US
economy hits full employment. Wage growth has increased from 1.5% Y/Y in
2012 to 2% currently and we see wages rising further in 2016. Negative.

15%

8%
6%

Cost of goods sold: COGS is the next line item which captures the costs of goods
sold during the quarter. With declining commodity costs and low inflation, COGS
has been declining, resulting in high gross margins. Given our cautious view of
commodities we see this trend continuing resulting in high gross margins.
Positive.

10%

Source: Bloomberg, Raymond James Ltd.

Interest Expense and Taxes: Corporate interest expense has been declining
steadily for decades as interest rates have fallen. According to Credit Suisse,
lower borrowing costs have accounted for a quarter of the margin improvement
since 1990. With the Fed expected to begin hiking rates, corporate borrowing
costs could rise from current levels, although we see rates remaining low for a
while. We see no changes to tax rates over the next year. Slight negative.

Consensus earnings estimates for 2016 signal further margin expansion to 11%. We
believe this is too high, and are modelling for margin compression of roughly 40 bps
to 10.25%, as higher wages and interest expense negatively impact margins.
S&P 500 Net Income Margins Are At Record Highs
12

Higher Wages Negatively Impacts Margins

14%

42%

Corp. Profits Before Tax As % Of GDP (LHS)

13%

11

Wages & Salaries As % Of GDP INVERTED (RHS)

43%

12%

10

11%

44%

10%

9%

45%

8%

46%

7%

S&P 500 Net Profit Margin

6%

47%

5%

Average Since '99

5

4%

'99

'01

'03

'05

'07

'09

Source: Bloomberg, Factset, Raymond James Ltd.

'11

'13

48%
'85

'90

'95

'00

'05

'10

Weekly Trends

December 11, 2015 | Page 3 of 4

S&P 500 2016 Forecast

Incorporating our 2016 macro forecasts of 2.3% US real GDP growth and 1.5%
inflation into S&P 500 sales regression model, we estimate that S&P 500 sales will
grow by 4.5% in 2016. Applying our 10.25% net income margin estimate, and 1% for
stock buybacks, we forecast S&P 500 2016 earnings of $123.96/share, which equates
to 5.9% Y/Y growth. Given our more modest economic growth expectations, our S&P
earnings estimate is roughly $3/share lower than current consensus of
$126.52/share.
Currently the S&P 500 is trading at 18.7x trailing earnings, which is two multiple
points above the long-term average of 16.5x. Assuming no multiple compression,
that would equate to a 2016 year-end price target of 2,320, on our forecasted EPS.
However, given the prospect of Fed tightening and other potential risks to the
economy/stock market, we expect some P/E compression in 2016, and therefore are
using a P/E target multiple of 17.5x. Multiplying our S&P 500 $123.96/share earnings
estimate by our projected 17.5x P/E multiple, we derive a year-end price target of
2,170. If realized, this would equate to an 8% total return, including a 2% dividend
yield.
We will provide our S&P/TSX Composite Index price target in our upcoming 2016
Market Outlook.
S&P 500 2016 EPS Forecast
$128.00
$126.00

S&P 500 Trailing P/E

$126.52

Raymond James Ltd

Consensus

35

S&P 500 P/E

Average
+1 SD
-1 SD

30

$123.36

$124.00

25

$122.00
20

$120.00
$118.00

15

$117.00 $117.00

10

$116.00

$114.00

$112.00
2015

Source: Bloomberg, Raymond James Ltd.

2016

'54

'59

'64

'69

'74

'79

'84

'89

'94

'99

'04

'09

'14

Weekly Trends

December 11, 2015 | Page 4 of 4

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product of the Research Department of RJL.
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be based on technical analysis and may or may not take into account information contained in fundamental research reports published by RJL or its
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