As investors brace for a third straight quarter of corporate earnings declines, a key profit gauge that flashed warning signs before the Great Recession now suggests that a new economic downturn is "imminent," according to Albert Edwards, the co-head of global strategy at Societe Generale. While aggregate corporate earnings compiled by organizations such as S&P and FactSet were sharply trending upwards through 2018, profits actually peaked in late 2014, per the comprehensive economic data series reported by the U.S. government, according to Edwards, per a detailed story in Business Insider

"This divergence is quite normal just before a recession," Edwards writes in recent note to clients. He added that the government data is "a truer representation of the underlying trend."

Key Takeaways

  • S&P data shows corporate profits rising through 2018.
  • Per U.S. government data, profits actually peaked in late 2014.
  • The government includes private firms and uses tax return data.
  • Many companies have little incentive to inflate taxable profits.
  • Peaking profits, per government data, signaled the last recession.

Significance For Investors

S&P data shows that corporate profits soared by 36% in the 4 years through 2018, as analyzed by professor Aswath Damodaran of NYU. However, S&P 500 profits were down on a year-over-year basis in the first two quarters of 2019, and projected to fall by 3.7% in 3Q 2019, per FactSet Research Systems. The consensus estimate currently calls for a 3.2% increase in 4Q 2019, and a slim 1.3% increase for full year 2019.

Government data suggest that those consensus estimates, which are based on S&P data, also may be too optimistic. "In stark contrast to booming stock market measures of profits, the BEA's NIPA have essentially flatlined for the last few years," Edwards counters. He refers to the National Income and Product Accounts (NIPA) data assembled by the U.S. Bureau of Economic Analysis (BEA).

Among the major differences between S&P and NIPA data is that the latter is much broader in scope, also including private corporations and S corporations, per the BEA. Additionally, the NIPA data is primarily compiled from tax returns filed with the Internal Revenue Service (IRS), and thus may differ from profits reported by the public companies in the S&P database that use Generally Accepted Accounting Principles (GAAP). There are other differences as well, notably the fact that NIPA data attempts to capture profits from current production.

A critical reason why Edwards prefers the NIPA data is precisely the fact that it is based on tax returns submitted to the IRS, MarketWatch reports. For example, private companies have no incentive to inflate their taxable profits, while public companies do have such an incentive with their profit reports to the investing public. He also indicates that profits at smaller, domestic-focused private companies may be a better indicator of the U.S. economy's direction.

The pessimistic view that Edwards has of the U.S. economy's direction is bolstered by the fact that the NIPA corporate profit data for 1Q 2019 saw a drop of almost 10% from the initial estimate to the final number. “The latest revisions to U.S. whole economy profits--National Income and Product Account profits--were sufficiently large to suggest that the end of this record economic cycle is much closer than previously thought," he observes, per MW.

Looking Ahead

It is at this stage of the aging economic cycle, says Edwards, that whole economy profits and profit margins plunge, even though this deterioration does not usually appear in stock market-reported profit measures until much later, in the middle of ensuing recessions. That's "when companies sack their CEOs and write down years of inflated profits growth in one fell swoop,” Edwards says, per MW. If the strategist is right, investors can expect more sharp profit declines ahead from public companies and a spike in turmoil in the executive suite.