Wednesday, June 07, 2017

NIPA Earnings Weakness Leads IBES S&P 500 Earnings Weakness

The equity market seems to know only one direction and that is up. The result of this type of pattern has been a downward trend in volatility with the VIX trading at a near single digit level. One characteristic of a low VIX reading and a higher trending market has been the absence of any significant equity market pullback. As Urban Carmel, author of The Fat Pitch blog notes,
"SPX [S&P 500 Index] has now avoided a 5% drawdown since November 4, a period of 139 days. Since 2009, there have been only two uninterrupted uptrends that have lasted longer: 142 days (ending January 2014) and 158 days (ending September 2014). If past is prologue, then SPX appears likely to have a 5% correction before June 23 (158 days)."
I am not sure time in and of itself is a predictor of a 5% equity market correction, but the data is confirmation of the lower downside volatility recently experienced by the equity market as can be seen in the below chart.

The seemingly uninterrupted move higher in the market has some concerned about the market's valuation. One measure getting quite a bit of attention is the Shiller P/E with a recent value of 29.2 times and above the level reached in 2007. This is above the S&P 500 Index trailing P/E multiple of 21.6 times or the forward P/E multiple of 17.8 times. Another valuation measure is a P/E based on NIPA profits. This P/E is about 15 times and just slightly above its long term average.

I discussed in a post late last year that stocks tend to trade at higher valuations in a lower inflation environment; however, there appears to be a sufficient number of P/E valuation measures to justify ones point of view on the market's valuation, i.e., under valued, over valued or fairly valued. Even if one believes the market is overvalued, the market does not tend to correct simply because of a stretched valuation. Often some unforeseen catalyst triggers the market correction with valuation a factor in the significance of the prospective decline.

Mid year last year I discussed in a number of posts that our firm's favorable market outlook was partially predicated on an improving earnings outlook unfolding for this year. This has played out as expected and earnings expectations for 2018 are looking equally as favorable, i.e.., low double digit growth. Not having the crystal ball on unforeseen events, stock prices tend to follow earnings and the double digit earnings growth outlook through 2018 is a favorable factor for stocks.

An interruption of the earnings growth would likely trigger a market pullback; therefore, are there factors that may warn investors of a potential slowdown in earnings growth?

In the P/E chart noted earlier, I mentioned the P/E calculation using NIPA earnings. Corporate profits measures from the Bureau of Economic Analysis (BEA) national income and product accounts (NIPA) can provide insight into future changes in S&P 500 earnings as reported by S&P Dow Jones Indices.  As background, the BEA uses the NIPA profit figure in its calculation of GDP and it is the BEA's featured measure of corporate profits. The NIPA corporate profits number is,
"profits from current production provides a comprehensive and consistent economic measure of the income earned by all U.S. corporations. As such, it is unaffected by changes in tax laws, and it is adjusted for nonreported and misreported income. It excludes dividend income, capital gains and losses, and other financing flows and adjustments, such as deduction for “bad debt.” Thus, the NIPA measure of profits is a particularly useful analytical measure of the health of the corporate sector. For example, in contrast to other popular measures of corporate profits, the NIPA measure did not show the large run-up in profits during the late 1990's that was primarily attributable to capital gains."
What is useful with the NIPA profits is the fact it covers a larger earnings base for the U.S and covers more industries as it is not limited to public companies. Additionally, the NIPA figure makes an effort to adjust for the differing accounting measures being utilized by companies.

Not surprisingly, the NIPA profits figure has a high correlation to IBES S&P 500 forward earnings, nearly 1.0. However, NIPA profits peak five quarters before IBES S&P 500 forward earnings as can be seen in the below chart.

A more detailed discussion on the comparison of NIPA profits to S&P 500 Profits can be found in this BEA Briefing (PDF). In the definition of NIPA profits earlier, it is noted that some of the factors that go into S&P 500 earnings that may be positive are adjusted out of NIPA profits. Some of the negative detractors from S&P earnings are adjusted out as well. Additionally, NIPA profits incorporate a larger company universe and may show earnings weakness in smaller non public companies sooner than what appears in S&P 500 earnings.

Lastly, incorporating the ratio of the Shiller P/E divided by the NIPA P/E (blue line below) this exhibits a high correlation to the S&P 500 Index as well, .85. However, the ratio peaks ten quarters before the market tends to peak. The ratio peaks eight quarters before a peak in IBES S&P 500 forward earnings. The most recent peak in the P/E ratio occurred in Q4 2011 and IBES earnings peaked in Q4 2014 (near the 10 quarters suggested by the historical data) and essentially moved sideways for two years before the recent resumption in earnings growth.

All else being equal, given the positive trend in earnings, the low level of inflation and a favorable equity risk premium, stocks are still attractive in spite of some valuation metrics being elevated.

If history plays out as noted in the chart data above, a rise in the Shiller/NIPA P/E ratio may need to occur before the market encounters a more protracted pullback. With the economic and company underpinnings seemingly okay a five to ten percent pullback during this bull market advance should be expected by investors though.

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