The latest deluge of U.S. corporate earnings reports begins next week, which means that investors will soon be subjected to an endless stream of commentary about what all those hundreds of profit results mean for the broad economic outlook.
Here's a simpler alternative: Ignore the reported figures.
Look instead at the aggregate figure for corporate earnings calculated by the U.S. Bureau of Economic Analysis.
Known as NIPA profit, it's the number no one focuses on – which is a pity because it offers a better guide to the state of the nation than the figures reported by companies. Calculated as part of the National Income and Product Accounts (hence, NIPA), the government-approved earnings figure is intended to do just one thing: measure profits from current production.
In contrast, the numbers reported by U.S. companies are figured out according to standards known as Generally Accepted Accounting Principles, or GAAP. Most of the rules are laid down by the Financial Accounting Standards Board, a not-for-profit organization that attempts to devise guidelines that will force companies to divulge the total amount of wealth they created, or lost, during the period in question.
That's a matter subject to much interpretation – for one thing, it involves not just profits from current production, but also such things as restructuring costs and the changes in the value of some assets held by a company. Management has considerable discretion under GAAP rules and can use it to move profits up or down. By contrast, NIPA profits are ultimately based on tax accounting rules, a system that offers far less leeway for ingenious managers to engineer the numbers they would like to see.
Comparing NIPA profits to GAAP profits over the years shows an interesting pattern, according to a recent paper by Emory University professor Ilia Dichev. The two measures were in "remarkable sync" between 1950 and 1980, but from 1980 onward GAAP earnings suddenly become 10 times more volatile. Since the two measures should, in theory, move together, it's clear that something beyond economic fundamentals is at work.
One possibility is that managers are deliberately choosing to use GAAP to make their reported earnings more volatile. This isn't as nutty as it sounds. Managers are typically rewarded with stock options and other incentives that are tied to profit gains. They can do well by making earnings as horrific as possible during a bad patch, then profiting from bonuses tied to the subsequent rebound.
Andrew Smithers, a British economist, says the "bonus culture" of executive compensation that has taken root since the 1980s offers the best explanation for the new volatility in GAAP profits. He also suggests that the same obsession with bonuses is behind companies' current reluctance to invest their cash hoards in building new productive capacity. Spending money on new factories or equipment would reduce the short-term profits that managers' compensation is based upon, so companies are choosing to buy back their shares instead.
That's all conjecture, of course, but what is clear is that NIPA profits are calculated on a more consistent and rigorous basis than GAAP profits. Investors should keep that in mind as they contemplate the current divergence between the two measures.
GAAP profits have been spectacularly healthy in recent years and continued to forge ahead in the first quarter of 2014. But after climbing vigorously since 2009, NIPA profits took a nasty tumble in the first quarter of this year. That may be simply the result of the unusually harsh winter. However, if the dip in NIPA profits continues when new data is released in August, it will be time for investors and forecasters to turn cautious – no matter what the GAAP numbers say.