As was mentioned in a previous article, the 12-month earnings which includes Q1 2017 are below the Q3 2014 peak. This 6.3% decline cannot be emphasized enough given misleading headlines about earnings growth driving stocks higher. If earnings falling didn’t push stocks lower, you can’t make the case that earnings growth is pushing them higher. While earnings are down 6.3%, margins are much closer to their peak. Margins peaked at 10.10% in Q3 2014; they are now at 9.95%. That’s only about a 1.5% decline which signals revenue growth hasn’t rebounded as quickly as earnings have.

One aspect of the debate between the bulls and the bears is whether margins can stay at their peak. The bears have the upper hand in this debate because margins mean reverting is only one part of the bearish thesis, while bulls rely on record margins to support their optimism. The point I’m making is that even with peak margins, stocks are expensive. If revenues and earnings were to grow indefinitely at a 7% clip, stocks would still be expensive. The chart below shows the forward earnings estimates as compared to a fixed 7% growth rate. Usually at the end of cycles, the forward earnings growth gets ahead of that 7% growth rate, but even with record margins, earnings have not yet exceeded that fixed line in this cycle.

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Bulls believe that earnings won’t revert to their mean because of technology stocks. This reminds me of the technology bubble in the 1990s where believers argued that stocks didn’t need profits to be good investments. They were correct in the short run as firms without profits had great performance for a few years. The current crop of late cycle bulls have also been correct, but their proposition is wrong. Firstly, firms will always succumb to competition which will shrink margins. Firms with economies of scale which have natural monopolies like Amazon, Google, and Microsoft will have longer periods of plateauing margins, but in a free market upstarts usually take market share through innovation. One example of this is how Facebook changed search by introducing people.

Even if the few tech giants could maintain high margins indefinitely, it still doesn’t mean the aggregate margins can stay high. In Q1 2017, information technology will represent 21.84% of S&P 500 earnings. If the other sectors had their margins revert to the mean, the aggregate would fall. This idea that firms other than the big technology firms will see their margins decline is not a prediction because it’s already happening. As you can see from the chart below, S&P 600 (the small cap firms) margins, have been falling since late 2013. This peak in margins preceded the S&P 500’s margin peak, but it hasn’t rebounded. If some large cap firms start to feel this pain, earnings will fall. Small businesses are the bedrock of the labor market. The weaker their profit growth is, the weaker the labor market will be. This hurts the consumer which hurts large firm’s margins. If the larger firms continue to buy smaller firms and grow their employment rolls, they will become less nimble which will hurt their ability to innovate. Therefore, the lifecycle of firms exists. The reality is not as cookie cutter of a definition, meaning firms don’t grow, mature, and decline, all in the same way, but eventually it happens to them all.

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A microcosm of this scenario aggregate earnings is going through is Caterpillar. Caterpillar finally reported a decent quarter. The firm’s machine revenue grew 1% which represents the first increase in over 4 years. The chart below breaks down the retail sales by region. As you can see, the Asia/Pacific region pushed sales growth to the positive side. Q1 earnings per share came in at $1.28 which beat the consensus of $0.62. Full year earnings guidance was raised from $2.90 to $3.75. The consensus was $3.26 which means the raise isn’t as great as it looks.

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The way Caterpillar’s situation is related to aggregate earnings estimates is that the company made $4.18 in recast earnings in 2015 and $3.90 in recast earnings in 2014. It’s way off the recast earnings high of $9.95 in 2013. Recast earnings are meant to make historical comparisons on an apples to apples basis which is why I’m using them instead of reported earnings. On April 27th, 2015 Caterpillar stock was at $85.33. The stock is now at $104.38. Therefore, the stock has increased 22.3% while earnings have fallen 3.8%, assuming Caterpillar hits its 2017 EPS guidance. This situation is analogous to a parent throwing a party because his child received a C minus on his report card because the child usually fails. The fact that Caterpillar is near its record high even though earnings are less than half their peak is evidence of a bubble. When the stock hit a record high previously, it fell because the earnings weren’t sustainable. At least it had unsustainable earnings then. Now there’s much less earnings, but investors don’t seem to care.

A final point worth noting is consumer confidence fell in the latest Conference Board report. This is part of the trend I’m predicting. I’m expecting soft data to disappoint in the next few weeks. The Consumer Confidence Index fell from 124.9 in March to 120.3 in April. The Present Situations Index fell from 143.9 to 140.6. The hardest hit subcategory was the Expectations Index which fell from 112.3 to 106.7. I’m expecting consumers to continue to become more pessimistic as the labor market softens and the fiscal policy boosts fail to come to fruition.

Conclusion

Margins in the S&P 600 have declined since 2013, but large caps are still at record high margins. The pivotal question for the market is if the tech giants can keep aggregate margins up. Caterpillar had a decent quarter for the first time in over 4 years which has pushed the stock to near a record high inexplicably. The consumer confidence fell slightly, but the data remains strong which is why this report didn’t push stocks lower.