Once a thriving well of gains, the S&P 500 has shown a sudden resurgence, yet a veil of fallacy cloaks these recent advances. While it’s hard to ignore the speedy rebound, the driving force behind these gains lies not in authentic growth, but in the deceptive nature of multiple expansion. Earnings estimates for both the fourth quarter and the first quarter of the impending year have taken a drastic plunge.

Projections for earnings growth over the next twelve months hover around a paltry 5.4%, holding potential to inch up further to roughly 10% in 2024, buoyed by anticipated earnings in the ballpark of $242. This optimism, however, seems unfounded, especially with the looming possibility of receding inflation rates, threatening to stunt sales growth.

Historically, sales growth has danced in close step with the CPI inflation rate. It is proving foolish, therefore, for analysts to anticipate an upswing in sales growth over the next year, despite an anticipated descent in inflation rates, which will likely lead to a grinding halt in growth rates.

As the inflation rate continues its decline, it should logically result in a parallel deceleration in nominal GDP growth. Correspondingly, this will manifest in a slowdown in sales growth rates for the S&P 500. Diminished economic growth and dwindling inflation rates will inevitably translate into a stagnation or even a decline in sales growth, necessitating margin expansion and increased buybacks to compensate for the dearth of sales growth.

The fervor for next year’s projected earnings growth is predominantly underpinned by margin expansion. However, recent PPI data suggests that margins are poised to constrict in 2024, rather than expand. The PPI Trade Services data for October reveals a year-over-year increase of a mere 0.8%, marking its lowest point since late 2019. This data is usually in harmony with S&P 500 margins over time, signifying that margin estimates are likely to wane over the next year.

Forecasted net margin estimates for the fourth quarter of 2023 and the first quarter of 2024 are already on a downward trajectory. This pattern is expected to persist, as labor costs linger above historical norms, while broader inflation across the economy recedes, making it impossible for companies to transfer their elevated costs to consumers.

Furthermore, a surge in buybacks will be necessary to lift next year’s earnings predictions should sales and margin expansion come up short. Buybacks have seen a decline from their 2021 peak of approximately $110 per share to a modest $90 per share at present.

Moreover, the number of buyback programs that have surged in the third quarter has plummeted to 13, with a mere 1 new buyback program commencing. Over the years, buybacks have provided a substantial lift to earnings growth. However, the current scenario indicates a rare instance of buybacks failing to wield the might that they once did.

Presently, the soaring S&P 500 rally has been predominantly fueled by multiple expansion, as opposed to a robust enhancement in the market’s earnings outlook. The predictions for next year’s earnings may be excessively sanguine, with investors paying an above-average PE ratio for a below-average anticipated growth rate over the ensuing twelve months. The current EPS growth rate correlates to a PE ratio of approximately 16.5, rather than the current 18.8.

When juxtaposed against a 10-year Treasury rate of 4.4%, the S&P 500 earnings growth rate offers a negligible 0.5 bp more than interest payments. In past instances of such narrow spreads, the PE of the S&P 500 has hovered around 16, dropping as low as 12 to 13.

This latest rally in the S&P 500 appears to stem from speculation about a brighter future and perhaps some positioning, rather than being grounded in a genuine improvement in prospects. Superficially, the prospects for the fourth quarter of 2023 and the first quarter of 2024 are corroding. If inflation lingers around the 3% mark and wage growth remains at approximately 4%, we can expect sales growth to falter, with margins deteriorating. These trends, in turn, will drive down earnings estimations over the next several months.