Visual Deconstruction Of S&P 500 Earnings Cycles

by: Attila O. Szabó


S&P 500 earnings (profits) are much more volatile than their revenues.

U.S. corporate profits are much more volatile than GDP.

The GDP cycle is not the primary driver of S&P 500 earnings, but rather the shifts between salaries and corporate profits -- which are mainly responsible for earnings ups and downs.

Currently, we are in an upward profit cycle, which has lasted for 14 years now and might continue if the same level of globalization isn't broken.

The goal of this article is to better understand the driver of earnings fluctuations, which might help us identify where we are currently on the stock market's roller coaster. There are a lot of articles on Seeking Alpha that try to figure out whether a boom or a recession is coming. Investors are wondering if the newer records of the S&P 500 are the end of a bull cycle and if a recession is on the way.

My conclusions (based on the analysis below) were that the sales/revenue cycle doesn't have significant impact on profits, and focusing too much on early indicators of GDP boom/recession is not that important. What really matters is focusing on the balance between salaries vs. profits, as the current historically high earnings are caused by a shift from salaries to profits.

As long as this salary/profit balance remains, the level of earnings (and stock prices) can be considered fair and definitely not as insanely deviated away from the baseline trend. If the salary/profit balance is breached, then there is huge downside potential in stock prices. Note that in this article I did not cover P/E; however, the current forward-looking S&P 500 P/E of 18.24 cannot be considered significantly overvalued.


The chart below -- which is of the S&P 500's aggregated revenues vs. historical earnings index -- shows that the volatility of earnings (0.48 to 1.49, so +/-50%) is much higher than the volatility of the revenues (0.87 to 1.1, hence +/-10%). This can be translated in a way that explains S&P 500 companies have a "relatively" steady turnover, while their earnings/profits fluctuate in a much wider range.

Source: S&P 500 earnings. The index is calculated based on yearly growth figures.

This implies that something is happening after the relatively steady sales, which makes the net profits more volatile. From an accounting point of view, the major decreasing items from revenue to net profit are listed below. The potential "guilty" item(s) should be searched for among these:

  • Cost of revenue
  • OPEX (including salaries)
  • Amortization
  • Interest
  • Tax

Unfortunately, I don't have the detailed data of the S&P 500 companies in time-series to analyze the reason for the volatility. Searching for the answer, I checked another data set: U.S. GDP volatility and the volatility of "corporate profit share in GDP" (see the two charts below).

Source: Fred, GDPC1. Exponential trend is fitted on annual figures. Deviation = GDP / Trend - 1.

Note that I use volatility and deviation as synonyms, with the definition of value/trend-1. The GDP cycle is calculated as the deviation from its long-term (70 years) exponential trendline, which is far from a perfect economical point of view. However, it shows a fair picture of the volatility, which wouldn't be more than +/-10% anyhow (except during the Great Depression, with +/-25%).

Corporate profit share in GDP is compared to its own long-term average below:

Source: Fred, CP. Deviation = Profits% / Average(Profits%) - 1.

This still doesn't answer the question of the volatility difference between sales/GDP vs. net profit, but shows the same pattern as above -- but on a much longer timeline. GDP "ups and downs" are much less intense (+/-10%) vs. the deviation of the "corporate profit share in GDP" (+/-50%).

For the sake of easier comparison, let's put only the two deviation lines on the chart:

Currently, we're at +30% regarding the profit cycle and -11% regarding the GDP cycle. The latter one is based on the non-scientific exponential trend; my more detailed, sector-based productivity analysis shows a -6% deviation from the long-term GDP trendline. Anyhow, the maximum upside potential due to the GDP cycle is around +14% (from -6% up to +10%), while the potential downside of the profit share cycle is -80% (from +30% to -50%) and +20% is the upside (from +30% to +50%).

So, the question is: When will this down cycle of profit/GDP happen? The frequency of these cycles are 10-20 years and this upward cycle started in 2003, so we have been in it for 14 years. It's hard to provide a good estimation on the timing, but what's more certain is that the next bear phase will be driven by a profit/GDP drop -- and this drop will be huge (potentially -80%).

To answer the volatility mystery: The chart below shows the employee compensation/GDP ratio vs. the profit/GDP ratio. The message is clear: Since 2000, the salary contribution to GDP decreased by ~5 percentage points, while the profit share increased by the same level. While this 5 percentage point change is not that much absolute terms, it is extremely huge relative terms, especially for profits. The salaries' share decreased by 10% (from the long-term average of 55% to 50%), while the profit contribution increased by +50% (from the long-term average of 6.5% to the 9%-10%-ish level, currently +30% up to 8.5%).

Personally, I think that the shift from salaries to profits is most likely driven by the increased level of globalization and the outsourcing of labor-intensive jobs to China/India (these things are widely discussed via the elephant-curve, Piketty, Trump, etc.). And if this level of globalization isn't breached, then this upward profit cycle should remain in place for longer -- perhaps longer than the usual 20-year cycle frequency.

Finally, let's put all the relevant information on one chart -- S&P 500 earnings vs. GDP and profit cycles -- to once again emphasize the primary driver role of the profit cycle:

Note: The profit and GDP cycle is based on the whole U.S. economy, while the earnings line is only based on the S&P 500 companies --hence, the ups and downs of earnings are not fully in harmony with the profit plus GDP cycles.


To sum up, GDP boom/recession cycles have much less impact on company profits and hence on the stock pricing. We are still in a long-lasting profit cycle in the upward range, and this cycle started in 2003. If the current level of globalization, foreign trade and peace remains the same, it might continue further.

Otherwise, a huge drop might come and it will be led by the drop of profit/GDP. Therefore, investors should focus on the balance of salary vs. profit contribution as any significant change in this split can have a huge downside impact on earnings and on stock 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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