Wednesday, March 30, 2011

Nonfinancial Corporate Earnings: Could They Keep Falling Until the Economy Passes Through Another Recession?

While I ponder aloud whether this is a healthy stock market for investors (as opposed to momentum traders), this will be my second post on the topic, following the last post that graphed long term trends in earnings.

I tend to avoid analyses that take the form of "whenever A happened in the last B years, then C occurred at least D percent of the time." Much of the time this indicates data mining to validate a favored conclusion, whether bullish or bearish. While this post risks getting closer to that territory than I'd like, I'm going to avoid actually calculating percentages and such and keep it vague and qualitative! I have no clear conclusions, I simply found the data interesting.

Here is a graph of nonfinancial corporate business profits after tax (NFCPATAX) and financial corporate business profits after tax (CP minus NFCPATAX) from the national accounts data, generated via FRED2.

  • Nonfinancial profits (the blue line) fell a nontrivial amount in Q4 2010. Have they peaked for this expansion? Or was there a special one-time event (such as an expiration of tax-friendly legislation) that explains it?
  • Look at the historical pattern of past occurrences of nonfinancial profits first starting to fall. If the drop was nontrivial in size, nominal nonfinancial profits continued to fall and only reversed course once a recession had occurred and was reaching its end! This process seemingly can take several years to occur (e.g., especially in the late 1990s).
  • The most obvious exception to the pattern is in the mid 1980s — a large drop in earnings was later followed by resumed earnings growth, with no recession.
  • Financial profits (the red line) in the period leading up to and through recessions have acted quite differently than nonfinancial profits. In the 1991 and 2001 recessions in particular, financial profits kept growing, largely unfazed by recession! This perhaps had a lot due to with the rapid growth in household debt as well as the steeper yield curve due to the Fed lowering rates.
Here is the same data ending in 1992, so that the vertical scale for the earlier years is more visible:

The pattern of nonfinancial profits peaking in nominal terms months or years before recession occurs seems similar but less pronounced than in the later periods. Note that I am intentionally graphing nominal profits in all cases, rather than a ratio such as to GDP. This is because stock prices are likely more sensitive to nominal profits than profits ratios.

A natural question for an investor would be, what are the implications for stock prices?

Here is a graph of nonfinancial corporate profits and the value of the S&P 500 index:

Does the point at which nonfinancial earnings peak represent an "overvalued" stock market price, given that recession often follows within a few years? It appears that in many cases, the stock market continued to rise after earnings peaked, and the eventual stock market low during recession wasn't always lower than the stock price had been at the time of that prior peak in earnings. Thus, waiting to buy stocks wouldn't necessarily have provided a lower entry point in the future. There are of course exceptions, for example the most recent recession taking stock prices well below their price at the time of the prior peak in nonfinancial earnings.

I can suggest no insights from this data regarding the eventual impact on stock prices even if the current contraction in nonfinancial earnings continues. The future direction of financial sector earnings may turn out to be a key determinant of the outcome. Plus, as is well known, valuation multiples expand and contract independently from changes in earnings.

Here is the same data repeated but only up to 1992, so the vertical scale for the earlier years is more clear:

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