Fed Easing Likely Can’t Drive Further Multiple Expansion
Markets are entering the Fall with valuations stretched relative to history. While the Federal Reserve’s pivot toward rate cuts has helped ease financial conditions, broad multiple expansion is unlikely to be the primary driver of returns, as the S&P 500 already trades at the upper end of its historical range. The market is entering a supportive seasonal patch from now into year-end, but seasonality is not a reliable market driver on its own. But what catalysts can carry equities higher from here?
Margins - The New Re-rating Mechanism?
In an equity market that is roughly 6 months removed from April’s price lows, we believe the companies that are best positioned for durable outperformance are those that can expand margins. Operating leverage, when revenues grow faster than costs, is allowing certain companies to turn topline growth directly into outsized earnings growth. This earnings efficiency is becoming the real driver of stock price re-ratings.
The megacap leaders in artificial intelligence and technology have shown the playbook. Their incremental revenues are dropping straight to the bottom line, delivering earnings per share (EPS) growth that far outpaces revenue growth. Consequently, highly profitable companies are commanding premium prices from investors. Within the S&P 500, the companies with the highest next-twelve-month price/earnings ratios have the highest expected profit margins, with an average of 21.1%. The lowest multiple S&P 500 stocks have an average NTM profit margin of 14.6%, a difference of 6.5%. With such a disparity between the most and least profitable S&P 500 stocks, investors appear to be incentivized to pay up for high margin stocks.
Not every company has the ability to flex operating leverage. Firms with bloated cost bases or margin pressures are being punished, creating dispersion across the market. For investors, this may mean selectivity matters more than ever. Identifying businesses with true positive operating leverage may become the differentiator in portfolio construction and a more durable source of returns than simply betting on a multiple re-rating. Since mid-August, the companies with the highest upward revisions to estimated operating margins have continued higher, while companies with stagnating margin outlooks have faltered.
A New Market Regime
The Fed’s pivot toward easing supports risk appetite, but with equity valuations already elevated, broad multiple expansion is unlikely to drive the next leg higher. Instead, operating leverage could be emerging emerging as the true differentiator: companies that can scale revenues while expanding margins are creating their own re-ratings through earnings growth. For investors, the focus should shift from hoping for higher multiples to identifying firms with real earnings power and efficiency.
Glossary:
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
Next twelve month price-to-earnings (P/E) leverages forecasted earnings to assess a company's future value, providing investors with crucial insights despite potential variability in estimates.
Profit margin is a common measure of the degree to which a company or a particular business activity makes money. Expressed as a percentage, it represents the portion of a company’s sales revenue that it retains as a profit after subtracting all of its costs.
Megacap is a designation for the largest companies in the investment universe as measured by market capitalization. While the exact thresholds change with market conditions, megacap generally refers to companies with a market capitalization above $200 billion.
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