It’s Late: So Says the Profits Spread and Leading Indicators

Whereas 2018 was a gangbusters year for earnings, P/E multiples contracted. On the other hand, 2019 has so far brought only marginal earnings growth, yet P/E multiples have expanded. Why you ask? It largely has to do with the macro/monetary environment. Last year, the Federal Reserve was raising interest rates, and financial conditions were tightening (especially in the fourth quarter). That is typically a recipe for lower multiples for the simple reason that earnings are less valuable when interest rates are rising and financial conditions are tightening. In addition, the stock market tends to discount forward earnings; and it was glaringly clear that 2019 was going to be a weak year relative to 2018.

Fast-forward to this year: the Fed went into pause mode in January and began cutting rates in July; alongside generally-looser financial conditions (especially in the first half). Additionally, the stock market is discounting an expected rebound in earnings in 2020. That has been a recipe for upward pressure on multiples. The rub is that unless there is a trade truce or some sort of deal; and if capital spending continues to weaken, 2020’s earnings estimates are likely too high.

I believe that we have probably squeezed about as much macro-based multiple expansion as we’re going to get; which means the market may “require” earnings to begin to do more of the heavy lifting. The outlook is less-than-certain.

What say you NIPA?

Relative to the standard of S&P 500 profits, there is a broader measure that is released alongside U.S. gross domestic product (GDP)—incorporating all public, private and S corporations. It’s the National Income and Product Accounts (NIPA) data assembled by the Bureau of Economic Analysis (BEA); with the data primarily compiled from tax returns filed with the Internal Revenue Service (IRS).

Why is the distinction important? Unlike public companies, private companies have no incentive to inflate their taxable profits; while smaller/domestic private companies are often a better leading indicator of the economy’s trajectory.

As you can see in the chart below, there is presently an extremely wide divergence between the S&P 500 index level and NIPA profits—similar to the gaps that developed around the past two recessions. This doesn’t necessarily mean impending doom; but does mean the direction of profits from here matters a lot. Ideally NIPA profits catch up to the S&P 500; but based on history, it’s more likely to be the opposite convergence.

Wide Divergence Between S&P and Profits

Source: Charles Schwab, Bloomberg, Bureau of Economic Analysis. S&P 500 as of 9/30/2019. *Profits as of 6/30/2019 and with inventory valuation and capital consumption adjustments.

Additionally, imbedded in the NIPA data above is a significant downward revision the BEA made to those profits this past summer. It was driven by the BEA’s initial underestimation of both unit labor costs and interest expense. You can see the pre- and post-revision lines for NIPA profits below.

Significant Downward Benchmark Profits Revision

Source: Charles Schwab, Bloomberg, Bureau of Economic Analysis, Federal Bank of St. Louis, as of 6/30/2019. Pre-revision represents 3/31/2014-3/31/2019. *With inventory valuation and capital consumption adjustments.

Regardless of whether ultimately S&P 500 earnings can manage a gain for the quarter; the spread noted above is yet another indication that we are likely firmly in the latter part of the economic cycle. Speaking of which, the job of leading indicators is to give us a heads-up as to when we’re likely facing an inflection point from expansion to recession.

Follow the leader

The Conference Board released its Leading Economic Index (LEI) on Friday, covering the month of September. The index fell by -0.1% after a downwardly-revised -0.2% in August. Among the LEI’s 10 components, strength in the Leading Credit Index and the stock market failed to offset negative contributions from the ISM New Orders Index and building permits; while the yield spread was a negative contributor for the fourth consecutive month. You’ll note, however, that both the 10-year/3-month and 10-year/2-year yield curves have since un-inverted; which is reflected in the table further down.

As you can see in the chart below, on a six-month rate of change basis, the LEI is plumbing the lows of the past two “mini recessions” since the end of the financial crisis; but still above the average decline heading into the past eight recessions.

LEI Descending Again

Source: Charles Schwab, Bloomberg, The Conference Board, as of 9/30/2019.

Let’s take a closer look at the components of the LEI. As I often remind investors, when it comes to economic data and tying it to stock market behavior; or using it to make a judgement about where we are in the cycle; better or worse tends to matter more than good or bad. That’s why, when I update the table below every month, I note not only the level of each component; but importantly their trends. It’s a bit of a sea of red in the trend column; which bears watching for further deterioration (and a more elevated risk of recession).

Source: Charles Schwab, Bloomberg, The Conference Board, as of 9/30/2019.

Finally, a new table I had my research associate, Kevin Gordon, put together shows the history of the current component makeup of the LEI (the caveat being that the components have changed over time as The Conference Board “refits” them to reflect the most relevant data during each cycle). It shows the percentage change in each component from the peak during each cycle to the first month of each recession; with the medians shown. Then, the final column denotes the change from the peak in this cycle for those components that are indeed past their peak (at least for now).

Source: Charles Schwab, Bloomberg, The Conference Board, as of 9/30/2019.

The combination of weak earnings growth, limited macro support for boosting multiples and leading indicators that are decelerating yet again imply the late-cycle view for the economy should remain the consensus. It doesn’t necessarily imply doom for stocks; but we continue to recommend investors keep their equity exposure at a level no higher than their long-term strategic allocation; while using volatility to consider rebalancing more frequently.

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see www.schwab.com/indexdefinitions.

©2019 Charles Schwab & Co., Inc. All rights reserved. Member SIPC.

© Charles Schwab

More Tax Planning Topics >