A mix of declining profit margins and rising interest rates could send investors to the exits.

Of all the factors that set the pace of Wall Street, two stand out: profit margins and interest rates. Profit margins measure how effectively management deploys capital in whatever businesses they pursue, while interest rates calculate the cost of money raised for these projects.

Both variables are critical in equity valuation models, determining whether it's time to buy equities or head for the exits. For instance, rising profit margins and falling interest rates push equity values higher, signaling a good time to buy shares. In contrast, declining profit margins and rising interest rates signal a good time to sell. 

For years, Wall Street enjoyed rising profit margins and falling interest rates, providing a double tailwind for stocks. Thus, the bull market we have seen in stocks.

However, in recent months, the situation has changed. According to FactSet, S&P 500 net profit margins are expected to decline for the third-straight quarter.

"The (blended) net profit margin for the S&P 500 for Q1 2022 is 12.1%, which is below the estimate of 12.3% at the start of the quarter (December 31)," said John Butters, vice president, and senior earnings analyst at FactSet. "It is also below the year-ago net profit margin of 12.8% and below the previous quarter's net profit margin of 12.4%. However, it is above the five-year average net profit margin of 11.2%.

"If 12.1% is the actual net profit margin for the quarter, it will mark the third straight quarter in which the net profit margin for the index has declined. On the other hand, it will also mark the fifth highest net profit margin reported by the index since FactSet began tracking this metric in 2008, trailing only the previous four quarters."

But that's a back-view mirror number before the Federal Reserve shifted its policy from lowering to raising rates.

"The conventional wisdom is that the market goes up when the Fed cuts rates, and it goes down, in aggregate, when the Fed raises them," said Chris Motola, a financial analyst at Merchant Maverick. "With the ongoing inflation crisis, the Fed is unlikely to deviate from its additional rate increases this year. Margin debt is down around 12% for the first quarter. This, of course, does not account for all of the leverage in the market, but given the timing could be a pretty bearish signal."

"Rising inflation combined with persistent slowing demand will lead to declining margins," said Bryan Cannon, CEO and Chief Portfolio Strategist at Cannon Advisors. "It creates an environment of stagflation that is very difficult for the government to solve. Raising the Fed Funds Rate will help control inflation. However, it will continue to dampen growth. On the other hand, lowering rates will help spur growth, leading to more inflation. The last time this occurred was in the early 70s and persisted for nearly a decade."

That wasn't a good environment for equities. The S&P 500 lost 14.31% in 1973 and 25.90% in 1974. That's why investors are already heading for the exits, with $15.5 billion left on Wall Street, according to EPFR data. And the situation could get worst if the Fed doesn't manage to bring inflation under control.

Still, different retail market segments will react differently to the new economic environment, according to Tradier CEO Dan Raju.

“The younger millennial and early-stage investors see how interest rate hikes directly impact their daily wallets and are likely to apply caution to their strategies and investing impulses,” said Raju. “Retail investors feel that short-term rate hikes will increase borrowing costs for average households and businesses, resulting in decreased spending. On the other hand, active traders, and most importantly options traders, will likely find unique investing opportunities created by the enhanced volatility.”