Clearly one of the more dramatic contrasts of the current cycle is that corporate profit margins rest near all time highs and consumer confidence currently sits at what have been prior economic cycle lows. Very different than what we’ve seen in prior cycles. Just what does this set of circumstances portend for forward corporate profit margin outcomes? This mismatch between record profit margins and historically low consumer confidence says the bulk of corporate profit margin expansion in the current cycle has been accomplished by cost cutting. Looking ahead, it's top line growth that will now be needed to maintain profit margins at these record levels, especially given the reality of a margin squeeze on consumers with the more than apparent mismatch between wage growth and that of living cost essentials (primarily food and energy). Moreover, as the recent productivity number show us, the low hanging cost cutting fruit has already been picked.
But there's one other wrinkle in the macro US corporate profit equation that at the very least deserves acknowledgement. For given all the accounting gimmickry and trickery of the current cycle, it just happens to be the industry least transparent and most questionable in its accounting practices has been responsible for the bulk of corporate profit recovery from the official nominal dollar corporate profit lows of 4Q 2008. Remember, the Street is characterizing the current cycle as a massive earnings recovery accompanied by all time high margins. Moreover, Street strategist after strategist is projecting record S&P earnings as support for equity index targets either rivaling or exceeding all time highs. But what about the quality of these corporate profit numbers? And maybe more importantly, does the financial market itself have something to say about this set of earnings quality circumstances? There are a good number of charts dead ahead so I'll move through this quickly.
To the point, using the most recent National Income and Product account numbers released a month or so back, 100% of domestic corporate profit growth in 4Q 2010 was due to the US financial sector. The non-financial corporate sector in aggregate experienced a very modest (1.1%) 4Q decline in profits. Moreover, again as of the current numbers, US financial sector earnings in 4Q were literally 4.9% away from all time highs recorded in the second quarter of 2006! You can see exactly what has happened over the last quarter century to both US financial and non-financial sector profits in the top clip below.
WOW! What a recovery. A massive success for the Fed and Administration in terms of bestowing close to trillion (Fed money printing and TARP) on the US financial sector, right? Of course the issue is we're looking at results from a financial sector whose potential forward balance sheet stress can neither be seen nor assessed. In a world devoid of mark to market accounting, where there's thought to be large shadow inventory balance in residential real estate, and the 2011 through 2013 period being the three largest years for commercial mortgage maturities on record ( trillion), we're banking on reported US financial earnings results to underpin a very meaningful portion of corporate profit and profit margin expansion story that is theoretically underpinning macro equity valuations. Feel comforted?
First, the world is not about to come to an end as during 4Q the US non-financial corporate sector still accounted for 67% of total US domestic corporate profits (not including foreign sourced profits). And at least up to the present, the rebound in non-financial sector US corporate profits has been pretty strong looked at on a cycle basis. In the following chart I trace the trajectory of non-financial sector corporate profits recovery in every US economic recovery of the last three and one half decades. Even with a slip in 4Q, set against historical precedent the US non-financial sector profit recovery trajectory looks good.
Moreover, we need to remember that the drop in non-financial sector corporate profits in the prior down cycle was not even as deep as what was seen in the 2001 downturn that was clearly led by the tech industry. For all the characterization of the prior recession being "The Great Recession", that indeed was not the case for the US non-financial sector. Not even close. The profits recovery seen in the top clip very much rivals what was seen in the post 2001 environment, which itself was a deep percentage dip for non-financial sector profits in aggregate.
So here we have Street strategists reaching for the skies with equity price targets and forward year(s) reported aggregate earnings estimates. But from the lows in US corporate profits in 4Q of 2008, it just so happens that the financial sector is responsible for 73% of the total improvement as per the NIPA numbers. With that type of recovery and nominal financial sector profits being just a hair away from all time highs, we should naturally expect financial stocks to have experienced the price recovery of a lifetime, right? They should be leading the pack to new all time highs since it's their earnings recovery that has led the macro corporate profit recovery, correct? And yet we see this.
At least for the notorious big banks, as a group prices are not even half way back to all time highs seen as financial US sector profits peaked in late 2006/early 2007. At least as far as the banks are concerned, the market sure as heck appears to be saying it does not believe the reported profits recovery vis-à-vis the US financial sector reported profit numbers. Let's face it, we all know the banks have meaningful balance sheet issues looking ahead, regardless of accounting shenanigans. But how about the US financial sector a bit more broadly as is embodied in the NYSE Financial Index. We repeat the same exercise as above with the NYK below. And as you can see, it's the same result.
Again, since no one can truly assess the risk on US financial sector balance sheets these days (and really a ton of financial equities globally, to be honest), I have absolutely no right nor inclination to proclaim that financial sector numbers cannot be trusted. All I’m suggesting is that we need to remember the key driver of the US corporate profits recovery is the financial sector. Reported financial sector profits are near all time highs. The only thing I can point to in order to suggest a question of quality of earnings is in order are the two charts you see above. Bottom line being, it sure appears that investors in the aggregate are more than willing to accept the macro corporate earnings growth story of the moment as a key underpinning to US equity prices in the aggregate. As witnessed by the tremendous price recovery in the major US equity indices over the past few years, investors are saying they implicitly believe the reported total corporate earnings results for both the financial and non-financial US corporate sector. Yet when we look at the lack of equity price recovery in the heart of the very US financial sector itself that is generating these supposed tremendous earnings results, we see something quite different. We see a complete disconnect. As expressed by price of both the Philly Bank Index (the BKX) and the NYSE Financial index (the NYK) investors are expressing notable disbelief in the apparent macro financial sector profit recovery in the headline numbers. So let's get this straight, US financial sector reported earnings are correct when assessing earnings for the macro US equity market, but incorrect when assessing the financial sector specifically (as witnessed by dichotomous stock price action)? Humble question being, how can both of these implicit/explicit investor assumptions co-exist and/or be correct as per the message of the market in simultaneous fashion? I do not have a good answer, and that's exactly why I’m bringing up this issue and suggesting it deserves perhaps more than a bit of thought.
Source: https://contraryinvestor.com/
