The Equity/Bond Ratio And S&P 500 Index Tell You All You Need To Know About NIPA Profits And EPS

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Includes: DIA, IWM, QQQ, SPY
by: Robert P. Balan

Summary

Financial market commentators sometimes misrepresent the relationship between payrolls, equity prices and NIPA Profits, a severely lagging variable.

Taken at the core, concurrent profits drive real-time equity prices, but we won't see that until one quarter later.

NIPA Profits data usefulness: provides indications of how the Equity Risk Premium will work out as long as 3 quarters ahead, and show EPS changes 4 to 5 quarters ahead.

In a core analysis, it is Corporate Net Cash Flow which drives NIPA Profits and equity prices, and even influences other economic variables such as GDP.

There is too much ado about nationwide corporate (NIPA) profits.

Here is one such example from Bloomberg News:

"Yet beyond the headline number, there is a reason for some concern. Corporate profits plunged 11.5 percent in the fourth quarter from the year-ago period, the biggest drop since a 31 percent collapse at the end of 2008 during the height of the financial crisis. For 2015 as a whole, pretax earnings fell 3.1 percent, the most in seven years, according to the Commerce Department."

"That's "bad news," said Nariman Behravesh, chief economist for IHS Inc. in Lexington, Massachusetts. History shows that when earnings fall, the economy often follows them downward into recession as profit-starved companies cut back on hiring and investment."

What is being alluded to is that in past business cycles, sometimes a sharp drop in NIPA profits was followed by actual decline in nonfarm payrolls 2 quarters later. See that in the chart below.

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In the first place, there have been false positives (as in 1985 and 1995), and second, the argument is putting too much weight in the impact of corporate profits to nonfarm payrolls. There could have easily been other factors, which caused nonfarm payrolls to decline. Moreover, the fuss over NIPA profits for us is so much ado about a misunderstood indicator.

What are NIPA profits?

These are corporate profits from current production, which represent the portion of the total income earned from current production that is accounted for by all U.S. corporations, including those, which are not quoted, some of which are subsidiaries of foreign companies. Profitability provides a summary measure of corporate financial health and thus serves as an essential indicator of economic performance. NIPA measure of profits is a particularly useful analytical measure of the health of the corporate sector, one which does not show profits attributable to capital gains. Moreover, the turning points in NIPA Profits generally come ahead of the S&P 500 Index itself, Earnings Per Share measures, and the S&P 500 P/E ratio (see chart below). It should be the starting point of any exhaustive equity market analysis.

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Even allowing for a reporting delay of 1 quarter, NIPA Profits provide good optics as to how the rest of the equity market data will evolve in the near future. We can see that in a multi-factor regression analysis (see chart below):

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There are several things in this regression chart that stand out:

  1. The equity price and profits are distinctly correlated, and the relationship is likely concurrent - that is a subject discussed in more detail, below.
  2. The evolution of Earnings Per Share (EPS) matches the movements of price and NIPA profits to some degree, but the EPS changes severely lag behind changes in both price and NIPA profits (by as long as 4 to 5 quarters). In my mind, that does not bestow any predictive characteristic on this variable. It is a follower - not a leader.
  3. EPS will likely fall over the next 2, even 3 quarters, but it would be immaterial to the near future outlook of both price and NIPA profit - these 2 variables would already be off towards a new direction (probably higher in our reckoning, continuing the current uptrend) even at a time that EPS is still falling.
  4. The differences in the process of determining the individual profits of S&P 500 companies and the nationwide corporate profits (more details below) would probably explain some of the small variations between the S&P 500 EPS and the NIPA Profits.
  5. But knowledge of the temporal sequence of these variables undermines the cult of EPS as a predictor of future prices - it is current equity prices (and the concurrent NIPA Profits that are implied) which will determine subsequent EPS, not the other way around.

Note that NIPA Profits and the profits published by US companies are defined in a very different way, and in recent years, they have increasingly diverged. The divergence is due to the much greater incentives for management to alternately over- and understate the "true" profits, and their much greater ability to do so. Simply put, profits published by companies have become even less "honest" than they used to be. This makes NIPA data much more reliable than those published by companies. One reason is that NIPA profits are part of the Gross Domestic Product when measured in income terms; and so this measure must equal, subject to small statistical discontinuities, GDP as a measure by expenditure. There is no similar check on the validity of the profits published by companies. We will highlight this correlation at the later part of the article.

NIPA profits highly correlated with Equity Bond/Price Ratio and the S&P 500 Index itself

NIPA profits are highly correlated with the Equity Bond/Price Ratio and intuitively indeed, with the S&P 500 Index itself. The basic relationship: profits drive equity prices. Moreover, it can also be shown that NIPA profits, in its nominal form, turn 1-2 quarters before inflection points in US equity markets. See that here:

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So if you know what state profits are in, that should provide indications of where equity prices should be going. It is a simple relationship - except for the fact that NIPA Profits data is reported 1 quarter late. Example: the NIPA profit data for Q4 2015 was just reported this week, a full quarter late.

That ceases to be an issue if you adjust for the reporting lag (move the NIPA data 1 quarter ahead), and this is what you get:

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What is the significance of the juxtaposed data?

This simple data tweak means that the equity/bond ratio or the S&P 500 price has become the predictor of the NIPA profit itself. How? If profits drive equity prices, it is easy to make the short leap of faith that equity prices have been rising because the NIPA profits have been rising as well (and vice versa), although we would not know that until a full quarter later.

How can we prove this to be true?

A simple graphical analysis will prove or disprove this thesis. If the S&P Index price is indeed a real-time manifestation of the much-delayed NIPA profits, then change rates in the real-time S&P should also eventually be seen in the changes in rates in the much-delayed NIPA profits. And we see that to be generally true, below:

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The graphical analysis shows other details as well. It implies that December 2015-February 2016 NIPA profits have fallen, but have been rising since then - and we can make that link simply because the S&P 500 price and equity/bond ratio are showing us those details.

If NIPA Profits lag behind real-time equity data, of what use is it?

NIPA Profits, by construction, lag behind real-time equity data and the equity/bond ratio, but it is very useful in one respect - it leads the Fed's Equity Risk Premium (the Fed Model) and a like-for-like S&P 500 Risk Premium (which compares the risk of investing in equities against corporate bonds - the real conundrum for most investors). Equity Risk Premium (*(ERP) properly defined is the expected return on stocks in excess of the risk-free rate. The ERP serves as a metric of how desirable it is in buying equities against holding bonds. In the Fed model, ERP is calculated as the equity earning yield less the 10yr Treasury long bond yield. In our like-for-like ERP, it is the S&P 500 earnings yield less the corporate BAA bonds. The Fed model is a universal metric of the attractiveness of equities versus bonds, while our S&P ERP limits the comparison to the S&P 500 universe.

We can show that changes in NIPA Profits provide as long as a 3-quarter lead over changes in the Fed's ERP model and the S&P ERP. See that in the chart below:

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Finally, where do NIPA profits come from?

Put differently, what is the primary factor that influences whether corporates, nationwide, turn in profits or not? As always, it boils down to funding - Corporate Net Cash Flow leads changes in NIPA Profits by 2 to 3 quarters.

Net Cash Flow is equal to undistributed corporate profits with IVA and CCAdj plus consumption of corporate fixed capital less capital transfers paid (net). It is a profits-related measure of internal funds available for investment (BEA). IVA is inventory valuation adjustment factors, and (CCAdj) is the capital consumption adjustment.

Net Cash Flow also leads major changes in US GDP growth by the same period. And this is one of our arguments why there is an unnecessary focus on NIPA Profits as a predictor of subsequent economic or asset price data: Cash Flow is the dog, NIPA Profits the spine, and equity prices or other micro-economic data (like payrolls) the tail of the dog. To complete the simile, Cash Flow is the dog that moves the spine (NIPA Profits) which wags the tail (equity prices).

See it in the chart below:

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Squaring the circle:

If Corporate Net Cash Flow can provide leads as to the future development of NIPA Profits 2 quarters ahead, then it follows that Cash Flow should provide clues as to the future trajectory of the S&P 500 broad market - and it does. Cash Flow tells you what to expect of the broad market as far as 3 quarters ahead. See that here:

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What the chart above implies is that it takes 2 quarters for the impact of funding to percolate into the business profit dynamics, and the profits then work concurrently into the equity price evolution. Subsequently, all of these come to a head when NIPA profits data are released, with a 1-quarter delay from real-time equity prices.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.