Earnings, Margin Debt And Moral Hazard

The S&P 500 has extended its record-long expansion, but the growth in earnings today may not be as good as it seems, cautions Jim Stack, money manager, market historian, and editor of InvesTech Research.

S&P 500 Operating Earnings have increased significantly and have helped fuel the 50% gain in the S&P 500 since mid-2016. On the other hand, Corporate Profits, which measures what all U.S. corporations earn, peaked in 2014 and is lower today than it was in 2012!

The reason for this discrepancy has largely to do with different accounting methods. Corporate profits are primarily calculated using tax accounting while S&P 500 earnings use financial accounting.

The methodology used to calculate corporate profits is more reliable for many reasons, including the fact that the Bureau of Economic Analysis adjusts for non-reported and misreported income.

Moreover, financial accounting can be more easily manipulated, and the management teams of large public companies take full advantage of this fact.

profit vs earnings

The current divergence bears a worrisome similarity to the Tech Bubble of the 1990s. The S&P 500 has a current P/E ratio of 24.6, which is in the 91st percentile of the last 92 years.

But taking into consideration the fact that today’s earnings have almost certainly been manipulated higher (which skews the P/E ratio lower), it becomes clear this is one of the most overvalued markets in history.

It’s also noteworthy that S&P 500 earnings are expected to contract by -2.0% in the fourth quarter of 2019, demonstrating that the most recent rally has been driven more by sentiment than fundamentals.

The dangers in this market are unmistakable, making it more important than ever to adopt a diligent risk management approach.

The ‘smart money’ market participants also seem to be aware of the questionable fundamentals of the most recent rally. Margin debt, which represents money borrowed to purchase stocks, ticked up in the latest reading but remains near the lowest levels of the past few years.

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Gary Anderson 1 month ago Contributor's comment

The Fed was slow to react to the housing crash in 2008. That made the Great Recession far worse. How will it react this time?