As regular as clockwork, equity analysts await “earnings season” in which publicly-traded corporation report on profits in the preceding quarter, and from there analysts make predictions on share prices going forward. The S&P has been reaching new highs in earnings per share (Figure 1).  A certain buoyancy has taken hold of the market based on “solid, good “ earnings reports. Judging by these earnings reports corporations are enjoying strong growth in profits. However, earnings do not tell the whole story of profitability.

Figure 1 S&P Earnings

The major distinction is that the S&P earnings reports are non-GAAP reports. The corporation has some considerable leeway to adjust net income to reflect so-called “one-time” losses or gains or to ignore losses from discontinued operations, for example. GAAP reporting is more rigorous and more consistent across industries. Profitability should be assessed from within the tax system as reported by the U.S. Bureau of Economic Analysis (BEA) in order to gain an understanding how profits have fared, especially since the 2008 crisis.

Overall corporate profit growth has mirrored the performance of the economy in general, remaining at a steady rate of 2-3% in real terms annually since 2012 (Figure 2).

Figure 2 GDP and Corporate Profits

The  BEA prefers a measure of corporate profit that reflects current production. According to the BEA,[1]

“This measure 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. “[2]

Viewed from this perspective, corporation profits are much less sanguine. Yardeni Reserach, Inc prepared a number of different calculations using the BEA profit numbers to demonstrate the weak performance of the profit sector in the national income accounts.[3] Two measures standout in this regard. Figure 3 examines profit margins from current production and they have been steadily weakening since 2012. Of greater concern is the historical relationship between falling profit margins and recessions. The data suggest recessions fall quickly on the heels of a couple years of falling profit margins. Profit margins have declined over the past two years, raising the prospects of a near term recession.

 Figure 3 Profit Margins

The other important correlation to consider is that between profit margins and capacity utilization, Figure 4.

With capacity utilization is at one of the lowest levels in over 20 years, just around 75%, it is no wonder that profit margins are under pressure. With this much spare capacity, the corporate sector is not operating at full efficiency which is necessary to achieve optimum profit margins.

Figure 4 Profit Margins and Capacity Utilization

Thus, while Wall Street analysts may cheer the recent earning results of the S&P 500, a closer examination of profitability tells a quite different story.

[1] https://www.bea.gov/national/pdf/ch13%20profits%20for%20posting.pdf

[2] Profits from current production, the featured measure of corporate profits in the NIPAs, is derived as the sum of profits before tax (PBT) and of two adjustments—the inventory valuation adjustment (IVA) and the capital consumption adjustment (CCAdj).

[3] http://www.yardeni.com/pub/ppphb.pdf