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opinion

Are investors paying attention to the growing gap between actual reported earnings and the scrubbed-down “operating” profit figures that are published for public consumption?

The game of fudging the data is back in vogue, a classic late-cycle development as companies find creative ways to hide the “bad stuff." So we’ll take it upon ourselves to play the role of detective so as to uncover the deception.

All the talk is about how two-thirds of the S&P 500 companies are “beating” estimates. If you believe that, I have an oasis for sale in the Sahara.

The current “spread” between actual GAAP (generally accepted accounting principles) and reported earnings now is some US$6 a share, or 15 per cent below what is being displayed on the TV screens as net “operating” income (“operating” is in quote marks because it is not the standard – earnings before interest and taxes – but rather how S&P reports them, which is “earnings after taxes that often exclude extraordinary items”).

In dollar terms, that spread is a non-trivial difference of US$200-billion. That’s pretty big. In fact, if you look at this entire cycle and go to the most comprehensive profits number there is – the $2-trillion of after-tax earnings from the latest available U.S. National Accounts data (including everything, listed and unlisted, from mom-and-pop shops to the mega caps) – it is actually lower in the 2019 third quarter than it was in the first quarter of 2012. Think about that – aggregate corporate profits derived purely from the activity the economy generates, as opposed to creative accounting tricks, have done diddly squat for the past seven years.

Over this time, the dollar level of “operating” earnings for the S&P 500 has managed to expand more than 40 per cent, and on a per-share basis, that becomes a 60-per-cent surge. That’s the real story here, and we have been harping on about it for quite a while now. There’s a disconnect between the stock market and the overall economy. The correlation has never been this low across all the cycles in the post-Second World War era. And that’s because the earnings that the large-cap companies are signing off on their statements bear no resemblance at all to the profits that are actually being generated.

This doesn’t mean that investors haven’t been richly rewarded. In 2019, S&P 500 companies bought back US$736-billion of their stock, mostly debt-financed, and also paid out US$486-billion in dividends. That’s a cool US$1.2-trillion in total payout to equity investors.

What is interesting, and at the same time disturbing, is how little of whatever cash flow that’s been produced was diverted into capital investment. No wonder we are on the precipice of a productivity recession. All of this is very late-cycle in nature. And the lack of willingness to commit real capital to the economy is now being mirrored by the dramatic slowdown in global deal-making as merger and acquisition activity in January was the weakest in seven years (big slowdowns in the U.S. and Asia-Pacific). Excluding a couple of huge takeovers in the health-care field, M&A activity has plunged 30 per cent on a year-over-year basis.

As an economist, I believe this speaks to one thing: lack of opportunity and lack of compelling valuations. Tack onto the mix an unusually elevated degree of economic and political uncertainty. In any event, this again is consistent with an expansion in its very mature stage. Invest accordingly, which means defensively.

David Rosenberg is founder of independent research firm Rosenberg Research and Associates Inc.