The Stock Market Has a Profit Problem

(Bloomberg) -- Package maker Sealed Air Corp. fell the most in six months Thursday after saying higher raw material costs would crimp the bottom line. A few days earlier it was rising freight outlays at Fastenal Co., where $1.1 billion of market value was erased. On Oct. 9, paint maker PPG Industries Inc. mentioned rising expenses. The shares cratered.

From railroads to retailers, signs of price pressures are starting to show at U.S. industrial companies, contributing to the worst October start for the S&P 500 since 2008. Equities have had their three worst sessions since April in the space of eight days, narrowly escaping a fourth straight down week thanks to a Thursday rally.

An earnings season everyone hoped would restore order has instead sent signals that the future is murkier than bulls realized, particularly on the inflation front, where many of their nightmare scenarios reside.

“That doesn't necessarily mean that we fall into a recession, but it should slow growth,” said Matt Maley, equity strategist at Miller Tabak & Co. “That is not good for a stock market that had been priced for perfection just a few weeks ago.”

It's not that earnings are weak. S&P 500 companies are on pace to expand profit by 20.7 percent in the June-September period and are headed for the biggest annual increase in eight years. The problem is the high hopes built into stock prices. Any sign rising costs are eroding the bottom line are ringing alarm bells for investors who have pushed stocks up 50 percent over 30 months.

“This leaves little room for a hiccup in the economy,” said Chad Morganlander, portfolio manager at Washington Crossing Advisors. “The environment is changing and yields are at the highest level they've been in a decade. This confluence of factors isn't a good one.”

Concerns like these may seem overstated in an economy where unemployment is at a 48-year low and consumer confidence a two-decade high. But investors with a sense of history are aware readings like these are more common at the end of rallies than the beginning.

Throw in President Donald Trump's trade war, currency weakness in emerging markets and a still-hawkish Fed, and it's a recipe for turbulence. The Cboe Volatility Index has averaged 17.2 in October, up 33 percent from the previous month. Among the casualties:

• Sealed Air fell more than 8 percent on Thursday. The Charlotte, North Carolina-based maker of Bubble Wrap cited higher-than-expected raw material and freight costs, along with currency headwinds, in guiding earnings lower.
• Fastenal slid 7 percent on Oct. 10. The Winona, Minnesota-based industrial supplier has been investing to ward off an incursion by Amazon.com and mentioned higher freight and wage costs in missing gross margin forecasts.
• PPG Industries tumbled 10 percent on Oct. 9. The Pittsburgh-based coatings maker said rising expenses and soft demand from China cut third-quarter earnings.

In a flat week for the S&P 500, old economy stocks bore most of the losses. Energy shares slid 1.9 percent, commodity producers lost 1.4 percent, and industrial companies fell 1 percent.

The S&P 500 Industrials Index is down 3.6 percent in 2018, compared with a 3.5 percent gain in the full index. Active manager ownership of in the group was at the lowest level since 2008 in August, Bank of America's data show.

Tighter margins go hand in hand with a market villain already on bulls' radar, rising interest rates, themselves a consequence of a strengthening economy and eight Federal Reserve interest rate hikes since 2015. While not a margin story per se, nowhere is the specter of rising borrowing costs more pronounced than in homebuilder stocks. The largest exchange-traded fund tracking the sector has spent 22 out of the past 25 sessions in the red, losing almost 20 percent of its market value in just a month.

Bank of America strategists including Ronan Carr say weakness is a buying opportunity. They're telling clients to go long industrials versus the broader U.S. market amid bets the headwinds are priced in and the sector will benefit from the bull market broadening out.

“While the trade clearly also has some correlation to the evolution of the global cycle and trade war risks, the sector exhibits strong fundamentals but has de-rated versus the U.S. market,” Carr said in a note on Friday. “The sector is a beneficiary of the capex upcycle we are seeing in the U.S., something our economists expect to continue.”

Margin pressure has been one of many sagas in the industrial space of late. Earnings-related concerns going beyond rising costs have been leading to intermittent blowups around the industry for weeks, in companies from United Rentals to Textron Inc. and Snap-On Inc. Outside of the U.S., shares of Daimler AG fell Friday after the automaker issued its second profit warning in four months.

“It doesn't mean the economy is going through a recession, but it's reality when the supply of labor tightens, labor is emboldened to seek higher wages, and business have to pay more,” said Marshall Front, chief executive officer and chairman of Front Barnett Associates LLC. “And the same time, demand is tight for raw materials, fees go up and prices go up. It's not the end of the world, it's something businesses have to contend with it.”

To contact the reporter on this story: Elena Popina in New York at epopina@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Chris Nagi

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