Concerns over the health of corporate profits continue to weigh on the minds of market participants, as was evidenced in a recent Bloomberg article – ‘Plunge in US corporate profits is economic warning sign’. The article references the following chart, and suggests that a decline in corporate profits can serve as an early warning sign of an impending recession in the US, illustrated by the red bars in the chart. However, we feel this is more an example of data mining than evidence of impending doom.
It is true that economic recessions have historically coincided with, or have been preceded by, declines in corporate profits – it stands to reason that corporate profits are impacted by the domestic economic cycle, as over half of S&P500 revenues are generated from the US. However, not all profit declines have been accompanied by economic recessions. Indeed, of 12 observed periods of negative YOY profit growth, only seven have seen recorded recessions.
Looking at the drivers of the current slump in S&P500 profits, we can make two observations, supported by the charts below.
- Most of the decline can be attributed to a drop in earnings within the commodity cyclical sectors of energy and metals & mining (left-hand chart)
- There is little evidence to suggest that weakness in the commodity space has spilled over into the broader corporate sector. Excluding commodity cyclicals, earnings have grown robustly over recent years, and indeed grew a healthy 7% in 2015 (right-hand chart)
Moreover, the weight of commodity cyclicals in the S&P 500 has declined from around 15% at the beginning of 2011 to around 7% today, so the base effect of declining earnings from this group becomes far less meaningful.
When we compare the present ‘profit recession’ to previously observed declines, the current period looks most similar to 1984–1986 when economic growth moderated from a high base (itself the result of a strong post-US recession recovery). Investment growth weakened while the oil price plummeted from $68 (Dec ‘83) to $25 (Sep ‘86), partly because of supply-side reasons and deteriorating credit conditions.
However, real household spending offset the investment slowdown and real GDP growth was a healthy 4% over this period. More importantly, the S&P went on to rise another 28% over those two years as the “oil dividend” boosted the purchasing power of American households. While this time round consumers have so far been more cautious about spending their oil price driven windfall, there are signs that this is starting to change (see this post from David Williams for more on this topic).
Reasons to be cheerful
It is certainly true that fear is a great source of catchy headlines and charts like the first one above can all too easily be used to fuel that fear. This has no doubt helped to raise concerns among some market participants over the general health of corporate profits, but we are optimistic – for those willing to actually cut through the data, and take history into account, the picture is not nearly as negative as it appears at first glance.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.