A post from Tom McClellan (The McClellan Market Report) on the PragCap blog provides a different perspective on earnings. Instead of looking at pure stock market earnings or profit margins, McClellan looks at Pre-Tax Corporate Profits as a Percentage of GDP, see chart below:
The conventional stock market analysis world revolves around earnings. “Earnings drive the stock market,” they say. This myopic view is akin to the belief that carbon dioxide is the driving force behind the greenhouse effect (water vapor actually accounts for 90-95% of it, but you don’t hear that). People believe that earnings are everything because they have been told that it is so, and everyone thinks so, therefore it must be so. Circularity of logic and contradictory evidence do not seem to be significant impediments to the acceptance of this belief system.
Why doesn’t Wall Street look at earnings in this manner?
My answer is that Wall Street has a fascination with its own forecasts of earnings, and with the reported earnings of listed companies stocks. But those are a pair biases which excluded private company earnings, and which also accept earnings estimates which are notoriously subject to revision. I prefer to deal in hard data.
So what exactly is the chart saying? McClellan believes:
What we see now is an indication that the reading for overall corporate profits as a percentage of GDP is at one of the highest levels of recent years. And when it cannot get higher, it can only get lower. It is true that this measure has been higher in the distant past, but that was back in the 1960s and earlier, when GDP was a bit different than it is now, and when accounting standards for measuring profits were also different. The current high reading has only been exceeded once in the past 46 years, and that was at the real estate bubble top for earnings back in 2006. And we all know how that ended.
My only concern with this analysis is the flawed logic that “when it cannot get higher, it can only get lower.” This statement is true, but no evidence is provided that the measure cannot get higher. We’ve seen markets rise higher than anyone ever thoughts (Japan stock market, Tech boom of the late 90’s and US Housing prices), but one must agree that the likelihood of going significantly higher seems low.
McClellan goes on to tell us what we should draw from the chart:
When profits get up too high, certain agents decide that “excessive” corporate profits are a worthy target to go after. So new taxes or other restrictive rules come into effect, and stimulative measures such as Federal Reserve policy which may help spur earnings to a higher level are pared back. Those twin agents have a negative effect on stock prices, or at least they have historically. Maybe this time will be different.
There are some more troubling conclusions:
The other troubling point about this chart is that the amplitudes of the swings from highs to lows in corporate profits seem to be getting bigger over the past 20 years. This measure formerly had much smaller magnitude movements, but the big swings we have seen during the last 3 boom-bust cycles resemble a spinning top that is starting to wobble just before it falls over and stops. Yikes! And at the point when profits as a percentage of GDP starts to fall, you can see in the chart what usually is happening then to stock prices. But remember that there is a reporting lag; we don’t even have Q4 numbers yet. So it is not as if you can wait for confirmation from the earnings data, and then decide how to invest.
One chart should never determine your investment strategy, but being mindful of the above should at least inform the potential risks that are out there.
Scott Dauenhauer, CFP, MSFP, AIF