Theoretically, stock prices are a reflection of the future expectations of earnings. If the expectations are that earnings in the future will be “X” and currently stocks are trading at a discount to those future earnings prospects then stock prices should rise. The issue today, however, is that those future earnings are now in jeopardy for a couple of reasons. First of all, corporate earnings have soard from the crash lows of 2009 as the economy recovered and from deep cost cutting measures which hit the bottom line. Today, those cost cutting measures are being reversed as employment increases and commodity costs rise. Secondly, net prices (prices paid less those received) are currently at levels that have historically impacted corporate profit magins negatively.
The impact to net prices are largely a function of the component costs to the manufacturing of products. In the most recent release of the Producer Price Index (PPI) we can see that the ratio of prices for crude goods, those used to make goods, to finished goods pricing is at a level that has only been hit 4 times in the history of the index. The simple reality is that the ratio is a negative for corporate profit margins as the rising cost of crude materials is unable to be passed on through equally higher priced finished goods. With consumptioin already struggling, which makes up 70% of the economy, the more the consumer is sapped of disposable income the slower the growth rate of the economy will be. This is why the Fed is keeping interest rates near zero until 2014 even as there are signs of tenative economic recovery.
Here is the clincher. Prices to the consumers are capped while the input costs are not. This sets up a severe “profit margin squeeze” like the coils of an anaconda around its prey. As prices tighten that slow constriction squeezes corporations struggling to maintain profitable spreads. This is why we see widespread use of temporary versus permanent hires, longer hours and stagnant pay. Eventually, the struggle will prove futile.
While ultra-low interest rates, Fed induced liquidity, accounting gimmicks and the benefit of seasonally warmer weather may allow for sustainability of earnings at record levels for a while; the reality is that the longer that higher costs are endured that can not be fully passed on to consumers the more likely we will begin to see a reversion in the earnings and profit trends. That reversion, particularly when prices of equities are reflecting nirvana of expanding GDP growth into the infinite future, can be larger than most are accounting for.