Stock market bulls have had plenty of reasons to hold on to stocks. As New York’s S&P 500 index has more than doubled since 2009, so US company earnings have more than doubled, with aggressive cost-cutting boosting profit margins.

This week, though, with the first quarter results season well under way, that narrative of belt-tightening and rising profitability has begun to look less compelling.

A s harp jump in oil prices and higher raw materials costs are weighing on earnings. These factors, combined with renewed nervousness about the eurozone debt crisis and weaker economic data in the US and China, has undermined the recent rally in equities.

Indeed, shares in companies ranging from IBM to CSX, the rail group, and Intel have suffered falls this week despite beating earnings expectations. Big US banks such as Wells Fargo, JPMorgan, and Bank of America have also lost steam after posting better-than-expected results.

True, a large majority of S&P companies are still beating analyst forecasts for results. But the wider market, sitting on a gain of just under 20 per cent from late November, is now on course for its first monthly decline since then. “Very few [companies] are raising guidance enough to suggest they can meet the market’s expectations for growth,” says Barry Knapp, chief US equity strategist at Barclays.

The question for investors is whether the pullback in the equity market heralds a sharper correction or lays the ground for a rebound that ultimately propels the S&P towards 1,500. Much will depend on whether earnings meet analysts’ lofty projections.

After posting record earnings of $99 per share last year, analysts forecast S&P companies will push upwards to $106 per share in 2012 and $118 in 2013.

“Looking at analyst forecasts, which are for record earnings this year and next, we’re scratching our heads as to how we get there,” says Channing Smith, a portfolio manager at Capital Advisors. “Profit margins are one of the most mean reverting indicators in finance, its just not possible for them to rise forever, the question is whether we see a rapid fall-off, which could presage a sharp market correction, or a gradual one.”

“The single biggest concern that we have about the market is the trajectory of corporate operating margins,” says Mr Smith.

Historically, earnings tend to revert back to their average over time and there is growing evidence this could be happening. According to FactSet, for example, analysts expect 105 S&P 500 companies will see their revenues rise but earnings fall this quarter due to higher costs, the highest in more than three years.

Earnings growth has outpaced revenue growth by an average of three to one since the start of 2010, according to data from S&P Capital IQ, as the operating margin of S&P 500 companies has climbed. But the latest batch of company results suggests this may not last. ConAgra, which owns a stable of food brands, is one company where rising costs are scuppering efforts to eke out higher profits.

“Input cost inflation in the [first quarter] was the most severe of any this fiscal year,” said Gary Rodkin, the company’s chief executive this month.

Consumer stocks suffer a double blow from rising energy costs, because not only do companies’ costs rise but households are hit by rising petrol prices, leaving less money for discretionary spending.

Cruise ship operator Carnival Corp, for example, reported that fuel costs rose 30 per cent year-on-year, accounting for nearly all of its $139m loss for the quarter, while General Mills, another food brand stable, saw its gross operating margin fall after the cost of ingredients rose 10 per cent year-on-year.

And there are signs, too, that productivity gains from cutting wage bills could be diminishing. Unit labour costs, which fell steadily during the financial crisis, increased at an annualised 3 per cent in the final quarter of 2011.

Bullish investors argue that thinner margins have already been accounted for in earnings projections and that a bigger test for the market lies later in the year, when earnings growth is expected to increase strongly. These investors argue, too, that a more convincing economic recovery in the coming months could compensate for margin compression through higher sales.

Others say that the S&P remains in the grip of a post-crisis trading pattern, with monetary largesse from central banks and developing market growth working alongside US corporate performance to sustain the recent rally. If margins are peaking just as emerging market growth stutters, then investors should be wary.

“Portfolios should be positioned for the reality of low growth, low rates and low inflation,” say analysts at Merrill Lynch Wealth Management. “Global growth is low and slowing, corporate profits will be pressured from historically high levels and central banks will continue to intervene.”

Additional reporting by Arash Massoudi

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