THE PROFIT PROBLEMS

CMG Wealth’s Steve Blumenthal recently posted this chart from Dave Wilson at Bloomberg suggesting that the S&P 500 Index has completely delinked from U.S. corporate profits, much like it did in the late 1990s. Steve’s conclusions:

• It is best to buy when prices are undervalued (price below earnings growth) – refer to the line in 2002 and 2009-2012.
• It is best to harvest gains when prices are overvalued (price way above earnings growth), such as we saw in 2000.
• U.S. after-tax corporate profits have been flat since 2010, peaked in 2014 and look to be trending lower. Looking at the blue price line relative to the white profits line on the far right-hand side of the chart. Looks a lot like 1999.
• Not positive for stocks.

The white line is after tax profits from all organizations treated as corporations in the national accounts as reported to the IRS.

Let’s revisit the “PROFIT PROBLEM” chart above, this time plotting S&P 500 stocks against S&P 500 profits: if there’s an S&P 500 profit problem, it’s certainly not as scary as in 1999.

The top chart does not include Q2’19 which hooked up a little as you can see below. With the Q2 data, corporate profits don’t “look to be trending lower” as much, do they?

But the FRED chart above reveals other, more significant, separations:

• corporate pretax profits in America have actually peaked in 2014 and declined 8.6% since. They are now only 11.6% above their 2006 peak, 14 years ago. Meanwhile, after tax profits have declined 1.6% since 2014 and are currently 30.6% higher than in 2006.
• By comparison, S&P 500 Index profits are up 38% since Q4’14 and 81% since their pre-crisis peak.

Here’s the real problem: total corporate profits in America have been flat since 2011 and have actually declined in the last 5 years. This while S&P 500 EPS have surged.

There are two main reasons for the S&P 500 strong earnings outperformance: foreign profits and share buybacks.

This next chart plots domestic (blue) corporate profits after tax (with IVA and CCAdj to include Q2 data) against foreign profits which have soared 32% in the last 2 years, 40% since 2014 and 140% since 2006 while domestic profits declined 4.3% since 2014 and rose only 32% since 2006. Foreign profits account for around 20% of total corporate profits compared with about 40% for S&P 500 companies.

GMO plots profit margins by market rank showing that only the largest companies have improved their margins since the turn of the century.

There may be several explanations. One is that the top firms are not necessarily the same over the whole period. Technology companies, which achieve much higher margins than average, saw their weight in equity markets rise significantly from less than 10% in 1995 to 22% currently.

Another explanation is that larger companies, including large IT companies, are more likely to export than smaller firms. U.S. exports ranged between 8% and 10% of GDP until 2006. The ratio soared to nearly 14% in 2015.

As exports soared after 2000 along with a declining dollar, foreign profits followed:

But U.S. exports, which rarely decline YoY except in recessions (and during the 2014-17 oil price collapse), have turned negative in the second quarter amid the Sino-U.S. trade war. Also, the greenback has appreciated nearly 30% in the last 5 years.

As a result, the rising contribution to profits from foreign operations could be about to end and even reverse. The chart below plots the YoY change in foreign receipts (revenues) against U.S. exports. Current odds would favor exports continuing to weaken with a likely similar trend in foreign revenue growth (which, surprisingly, hooked up to +5.8% in Q2, perhaps due to surging crude oil exports).

This next chart shows total corporate pretax profits (blue) broken down between financial (red) and nonfinancial (black) profits. Nonfinancial profits, which account for 55% of U.S. total profits, are currently 10% lower than they were in 2006 and 20% lower than in 2014.

Nonfinancial companies include technology and most exporting companies implying that profits of U.S. nonfinancial domestic non-tech companies must have done particularly poorly in recent years.

Ed Yardeni offers these telling log charts on aggregate dollar earnings for Financials and Technology companies within the S&P 500 Index. We can visualize the slowdown in total earnings post the Global Financial Crisis. In fact, Financials’ earnings are just barely above their 2007 peak, 12 years later. Talk about a lost decade! Financials supplied 26% of total S&P 500 earnings in 2007. It’s now 18%.

IT companies currently account for 19% of total earnings and appear to be growing no faster than total earnings on an aggregate earnings basis, in fact much slower (see lowest blue line below).

I also trendlined this Yardeni.com longer term chart to highlight how the GFC hurt profits of large public companies and how trends have really diverged since.

The same chart with trend lines from the pre-GFC peak in operating profits shows that S&P 500 profits are actually growing at a slightly slower pace than total corporate profits even when including the 2018 tax reform step-up.

An optimist might opt to focus on the last few years and see that S&P 500 earnings are simply in the process of closing the gap with NIPA profits but the reality is that the U.S. 1.7 million small, medium and not so large corporations are the real drivers of the U.S. economy. The fact that their profits, and profit margins, are doing so poorly during a long economic expansion, not only explains the lack of capex investments, but also must be a reflection of some negative fundamental trends that could (will?) eventually impact indices of larger companies.

Profit margins have really taken off post 2000 even though capacity utilization kept declining. These trends reversed in recent years:

This other Yardeni.com chart shows how profit margins diverged first between 2015 and 2017 and again in 2018. The collapse in oil prices between 2014 and 2017 hurt total corporate profits much more than S&P 500 profits. More recently, the tax reform benefitted larger companies much more than smaller firms.

The good news is that total corporate margins seem to have stabilized in the 8.5-9.0% range. The not so good news is that, based on the 30-year historical relationship, the odds are that S&P 500 margins will converge towards that range from their current 11.8% level. The last two economic recessions have proven to be great equalizers on that relationship but declining foreign profits, increased supply logistics costs as well as rising regulatory costs and competition in technology could initiate the downtrend even without a U.S. recession.

Factset estimates that companies generating more than 50% of their revenues from foreign markets will see their revenues decline 1.7% and their profits decline 10.7% in Q3’19.

Over time, S&P 500 profits generally ranged between 50% and 60% of total NIPA profits. That ratio was 71% in Q1’19, a level only reached 2 other times in the last 30 years. The odds are that mean reverting is under way.

To sum up this analysis of America’s profit picture:

• Total pretax profits of American corporations peaked in 2014 and have since declined 8.6%.
• After tax profits fared better thanks to the 2018 tax reform but they have shown no growth in total since 2012.
• Profits of nonfinancial companies, 55% of total corporate profits, are currently 10% lower than they were in 2006 and 20% lower than in 2014 and still trending down.
• Foreign earnings of American corporations have strongly outperformed, especially in the past 2 years but negative growth in U.S. exports amid the trade war with China, weakening foreign economies, a strong dollar and changing supply chain logistics are all seriously threatening this 20% slice of the profit pie (40% on the S&P 500 Index).
• Technology profits are showing signs of, at best, slowing down, at worst, peaking out. Many of the industry’s stalwarts are being dragged in long, distracting and costly regulatory battles in the U.S. and Europe.

Enter share buybacks.

Aggregate operating earnings of S&P 500 companies are up 26% since 2014 but earnings per share are up 35% as the share count declined 6.5% during the period. Since 2006, aggregate earnings are up 66% but EPS are up 80%.

• Financials (13%), IT (21%) and Health Care (15%) account for nearly 50% of the S&P 500 market cap. They have done 56% of the cumulative $4.9T in buybacks since 2009, 66% in the last 12 months and 69% in Q1’19 (per Ed Yardeni’s numbers).
• IT companies alone have done 26% of the cumulative buybacks since 2009, 34% in the last 12 months and 33% in Q1’19.

However, S&P 500 companies do not operate in their own different world:

• S&P 500 aggregate earnings are up 26% since 2014, that’s only 4.6% compounded annually.
• S&P 500 nonfinancial aggregate earnings are growing at a similar 4-5% pace but these companies account for 87% of the Index. Can nonfinancial large caps keep significantly outperforming all American nonfinancial corporations?
• IT companies, America’s greyhounds, have seen their aggregate earnings slow down in the past 5 years, actually to the overall market’s pace by one measure. IT companies in the S&P 500 Index derive 57% of their revenues from foreign markets per Factset numbers.
• Share buybacks plus dividends are now consuming 100% of total S&P 500 operating earnings as Ed Yardeni illustrates. Clearly unsustainable and undesirable.

• Actually, buyback announcements have declined this year:

Source: JP Morgan, @TeddyVallee (via The Daily Shot)

This blog is not in the forecasting business but seeks to understand trends and detect potential turning points, especially those that run contrary to consensus. Since 2009, I have often argued against bets on declining, mean-reverting, profit margins. Corporate America has time and again proven its vibrancy and capability to adapt and manage efficiently. Globalization and supply chain optimization particularly benefitted Americans’ entrepreneurship while technology advances clearly favored American corporate productivity and market share drives.

Many current trends suggest that tougher times are ahead and that investors should avoid trend lining profitability as foreign markets become less friendly, as technology companies need to fight increasing competition and regulations world wide, as labor costs grab a larger share of revenues and as corporations need to take better care of their financial ratios and curb share buybacks, simultaneously impacting shareholders’ cash returns and overall demand for equities.

Understanding and keeping track of these trends provide an edge to investors who can now set smarter odds about the future.