Sales and earnings are the basic components of a company’s profitability. As sales move up and down, a company can adapt their expenses to meet the net earnings requirements in order to preserve profitability. However, there is only so much a company can cut. Eventually, something has got to give.
Looking at the historical spread between quarterly earnings growth (year over year) and sales growth there is a good correlation to the price of the S&P 500, two quarters into the future. As spreads decline, it is a sign that sales growth is no longer keeping up with the pace of earnings growth and investors will re-price stocks.
Looking at the current and estimated spread shows that there is a significant gap building. In fact, analysts estimate that earnings growth will continue to increase at a healthy pace while sales growth stagnates. There are a few outcomes which are possible:
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