According to Standard and Poor’s, first-quarter earnings growth is expected to average only 0.5 percent, with six of 10 industry sectors actually expected to report earnings declines, which would be the worst performance since the financial crisis of 2008. Similarly, companies issuing negative earnings preannouncements outweigh those issuing positive ones by a 3-to-1 margin, the most negatively skewed ratio since the first quarter of 2009. The good news is that first-quarter earnings expectations are low, so we may be in a “sell the rumor buy the news” scenario.

Corporate Profit Margins are Peaking

The bad news is that this first-quarter earnings slowdown may be just the start of a prolonged decline. James Montier of the Boston-based asset allocation firm Grantham, Mayo & Van Otterloo (GMO) recently wrote a convincing article on corporate profit margins (i.e., profits divided by sales) entitled What Goes Up Must Come Down! His main thesis is that S&P 500 corporate profit margins are the highest in history at 7.8 percent (75-year average is only 4.9 percent), having been goosed higher by unprecedented government economic stimulus that is unsustainable given public debt levels. As the stimulus is withdrawn, corporate profit margins will be hurt and revert back towards the mean of 4.9 percent, yet analysts are expecting profit margins to continue higher! Montier concludes:

The government deficit may stay high this year, due largely to it being an election year. However, it is almost unthinkable that it will remain at current levels over the course of the next few years. Assuming that the government moves toward some form of deficit reduction plan, corporate profits are likely to struggle. It seems unlikely that “this time is different” when it comes to mean reversion in margins: what goes up must come down.

The future disconnect between analyst expectations and reality will hurt stock valuations and — according to Montier — cause the S&P 500 to experience an annualized real return over the next seven years of only 0.4%.

Andrew Smithers, author of the 2000 investment book Valuing Wall Street, similarly believes that a reduction in government fiscal deficits will hurt stock prices. Lower profit margins means less corporate cash flow, which will severely restrict companies’ ability to conduct share repurchases. Corporate buyback programs have been a big support for the stock market. Smithers sees stocks as 50 percent overvalued and, consequently, have a long way to fall once fiscal retrenchment takes hold in 2013. Smithers concludes:

U.S. equities are being kept up by corporate buying. This should continue until corporate cash flow falls, which is likely to coincide with a decline in the fiscal deficit. We don’t know when, or even if, the fiscal deficit will start to be reined in, but it looks unlikely to be postponed beyond 2013. At any rate, the stock market has every reason to be nervous as the November election gets nearer.

My takeaway: enjoy 2012 while it lasts!

Continuously rising gasoline prices – which are very close to their record high from July 2008 – are also a threat to corporate profits, as would be a new recession, which the Economic Cycle Research Institute (ECRI) continues to call for despite significant improvement in its own weekly leading index (WLI). In a March 15^th note entitled Why Our Recession Call Stands, ECRI criticizes its own “smoothing” methodology of year-over-year WLI growth and argues that people should look at the non-seasonally adjusted (i.e., raw) year-over-year growth rate in WLI which continues to be near its worst reading since 2009. Changing the rules of the game in the middle to support a recession call appears inappropriate to me. ECRI is losing some credibility in my eyes.

On the other hand, the Federal Reserve shows no signs of taking away the monetary punch bowl anytime soon despite recent strength in economic data. In a March 26^th speech, Fed Chairman Ben Bernanke said that the job market remains “far from normal” and “continued accommodative policies” are needed. More of the same in terms of monetary stimulus bodes well for financial assets in the short term, both stocks and bonds.