The Major Warning Flag Most Investors Are Missing
A week ago, I warned that an event was taking place that could spark the biggest correction since 2008. That day, the S&P 500 plunged 1.7% and the VIX shot up 22%. While traders panicked, I closed two trades for annualized returns of 1,205% and 2,111%.
Since then, however, the market has rebounded strongly as investors’ fears about Greece and China were temporarily assuaged. So, do I think we’re out of the woods?
Not even close.
Now I know some of you may be thinking things are getting better. Stocks are trading at all-time highs, the housing market seems to be recovering and unemployment is going down. Unfortunately, when you look closer at the numbers, you get a different story.
When I made my July 8 prediction calling for the most significant pullback of this decade, I pointed to four major red flags. While this secular bull market may still have some good years ahead of it, numerous warning signs foretell a correction in the near term.
Today, I want to discuss one of the red flags I’m seeing in detail.
Margin Tricks Creating False Sense of Earnings
One of the problems with this market is that business executives are running out of ways to “juice” their earnings as sales decline.
According to FactSet, revenue at S&P 500 companies is expected to fall 4.2% year over year in Q2. If analysts are correct, this will mark the largest decline in revenue since Q3 2009 and will also be the first time the index has seen two consecutive quarters of sales declines since 2009.
Yet as revenues have slowed, ultra-low interest rates have made money cheap, allowing companies to refinance debt with lower payments. Wages have been relatively stagnant over the past six years, keeping employment costs low. And record levels of stock buybacks have allowed companies to improve their earnings on paper without actually making more money.
These factors helped S&P 500 companies grow their earnings an average 15% a year between 2009 and 2015, three times faster than sales.
This phenomenon essentially boils down to one thing: record gross profit margins.
Gross margins show how much money is left over from sales after accounting for the cost of goods sold, expressed in percentage terms. This metric provides a unique window into the health of a company. Basically, if gross margins are high, it means a company is being run efficiently.
As you can see in the chart below, gross margins are the highest they’ve been in the past decade. That means companies are operating at peak efficiency — so they should be raking in cash.
However, profits are falling, which is a bad sign. If companies can’t grow their earnings when times are good, how are they going to grow them when things get bumpy?
Peak Efficiency Plus Falling Sales Could Equal Layoffs
To make more money in a stagnant sales environment, companies have aggressively cut costs. For some, there is no more fat to trim and the only thing left to do is lay off employees.
Many well-known companies have already begun to do this. Wal-Mart Stores (NYSE: WMT) is said to be eliminating 1,000 corporate headquarter jobs by Nov. 1. Kraft Heinz Company (Nasdaq: KHC), J. Crew, The Gap (NYSE: GPS), Target (NYSE: TGT), American Apparel (NYSE: APP) and many others are also thinning their ranks.
To be clear, I am not predicting mass layoffs, but rather methodical cuts to the workforce with higher paid employees being dropped for cheaper replacements. While this should keep unemployment levels appearing low, it could put strain on the economy.
Why Margins Have Me So Worried
Gross margins for the S&P 500 are at the highest level since the dot-com bubble. That period was a bit of an anomaly, however, as tech companies with little in the way of production costs were artificially inflating margins to astronomical levels. Nevertheless, by mid-2002, the S&P 500 had lost half of its value.
Margins were also elevated in late 2004, as China, commodities and housing all boomed, delivering huge profits that would evaporate a few years later in the biggest recession since the Great Depression.
The most recent surge in margins came in late 2010, as we were emerging from the Great Recession. In early 2011, I warned investors that they should be extremely cautious about buying anything. The S&P 500 went on to fall 18% in six months from its February 2011 high.
Today, the S&P 500 has a gross margin of 32.79%, even higher than it was in late 2010. What’s more, the bull market is now six years old, U.S. GDP growth declined in the first quarter, Chinese stocks are in a bear market, the Greek tragedy plays on and the Federal Reserve is nearing a rate hike after exhausting its stimulus arsenal.
While geopolitical events have dominated headlines and led to nauseating volatility, I fear investors are in for a rude awakening when the true driver of stocks takes center stage.
While the S&P 500 has been flirting with all-time highs this year, this number has been falling dramatically — leading to another massive red flag. In fact, the last time a reading like this was flashed was in October 2007, when stocks began a 17-month, 57% decline.
I detail this and two more serious red flags in a presentation I think anyone with money in the market needs to see. If you’re interested in protecting your wealth, I would act quickly.
In addition to explaining why I think we could see hundreds of popular stocks fall 10% to 30% over the coming weeks and months, I will cover a strategy that has made me annualized gains between 141% and 2,111% this year as stocks fell.
This article was originally published on ProfitableTrading.com: The Major Warning Flag Most Investors are Missing