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What Does The Equity/Bond Ratio And The US Corporate (NIPA) Profits Tell About Future S&P 500 EPS?

" The S&P 500 has been trapped in a nasty earnings recession for most of the last six quarters. That streak was finally broken in the third quarter when earnings increased 3.8% from the same period last year. Looking forward, S&P 500 earnings are expected to accelerate from here. Fourth-quarter earnings are expected to have grown around 5% and total S&P 500 earnings are expected to continue that growth to reach somewhere between 10% and 12% in 2017. I still expect this return to earnings growth to be a strong catalyst for the S&P 500 in 2017." Michael Vodicka, Street Authority

Some of the current angst about the equity markets stem from the fact that equity markets' Earnings Per Share has been flat since July 2015. This has been the case, despite significant gains in national corporate profits since the fourth quarter of 2014, and the significant gains in the Equity/Bond Price Ratio and in equity prices since the trough seen in February 2016. The current market pessimism is a sign that some equity analysts have given up on an EPS recovery this year. Should they? Since the first three market variables tend to lead EPS on a consistent basis, why can't we use those three variables to determine at least the direction of EPS for the rest of the year? It is important to understand the direction EPS are going because even if the data lags the three other market variables, it still has a large impact on equity allocations, and consequently, on equity valuation, reflexively.

Corporate profits measures from the Bureau of Economic Analysis national income and product accounts (NIPAs) and from Standard and Poor's (S&P EPS) are widely followed by analysts. The measures, however, differ significantly, reflecting differences in purpose, coverage, source data, definitions, and methodologies. In this article, the NIPA measures of profits and the Equity/Bond Price Ratio are compared with S&P 500 measures of reported earnings and operating earnings (NYSEARCA:EPS), so as to understand the relationship, which may give us leading indications of where the market is going. The comparison indicates that although long-term trends of NIPA profits measures and S&P earnings measures are broadly similar, concurrent short-term annual and quarterly growth rates can differ dramatically. For example, both S&P 500 earnings measures fall by larger percentages during recessions than the NIPA profits measures and then rise faster to converge back toward NIPA profits trends. But what if this is not the correct comparative procedure since changes in EPS have long lags relative to the changes of those other three variables?

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. As such NIPA profits show the impact of investments much earlier than EPS - this makes a lot of difference -- the turning points in NIPA Profits are ahead of with the Equity/Bond Price Ratio and P/E Ratio, and significantly ahead of the S&P Earnings Per Share measure (see graph above). It should therefore be the starting point of any exhaustive equity market analysis.

That graph above is very illuminating. Although the inflection points are dissimilar, there is a distinct temporal sequence of the inflection point of these four variables - NIPA profits, Equity Bond Price Ratio, P/E Ratio, and EPS - and if we can find the cadence, it might just provide a new procedure how to forecast the direction and extent of EPS in the future. 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. As earlier stated, US 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 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.

And where do the 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).

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 in the chart below.

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 chart below). 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 one quarter late. Example: the NIPA profit data for Q4 2016 was reported in mid-March, a full quarter late. That ceases to be an issue if you adjust for the reporting lag (move the NIPA data one quarter ahead), and what you get is shown in the chart below. The graphical analysis shows other details as well. It implies that NIPA profits have been rising since Q1 2015 and will rise further-- and we can make that link simply because the S&P 500 price and equity/bond ratio have been rising significantly over the past several quarters, and are leading us to those details, which are reported later.

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 delayed NIPA profits, then change rates in the real-time S&P should also eventually be seen in the changes rates in the delayed NIPA profits (see chart below). NIPA profits, by construction, lag behind real-time equity data and the equity/bond ratio, but it is very useful in one respect - even without temporal adjustments, it leads EPS by several quarters.

Conclusion: S&P 500 EPS have been flat over the past several quarters, but we are in the right time frame when EPS should start to head north, following the lead of the NIPA Profits, the Equity/Bond Price Ratio, the P/E Ratio and the S&P 500 index itself. The angst over earnings is, for us, unnecessary - given the significant appreciation of the other three variables discussed in this article, EPS should soon rise, and should keep on rising over the next four quarters at least, possibly until Q2 2018.

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