Currently we are seeing a repeat of the late 1990s, with the US equity market powering on, while profits, as measured by the National Income and Product Accounts (NIPA or GDP accounts) have been flatlining. This dynamic is being driven by the fact that reported earnings of the S&P companies have been much more robust, which the equity market has followed – while NIPA profits have grown 10% over the last 6 years, S&P earnings have grown by 50%.

NIPA and the S&P profit measures differ in both coverage and accounting methodologies. First, NIPA attempts to capture all US corporates, while S&P focus on large listed companies. Second, NIPA measures profits from current production, and does not include capital gains and losses. Lastly, NIPA is based on data collected from corporate tax returns, while S&P earnings come from financial reports.

The positive spin on this divergence is that US industry has become more “winner take all” with large companies taking all the profits, which is a new take on the “new” and “old” economy discussion of the 90s. However, previous experience has shown that when a significant gap opens between the two measures, S&P earnings have converged back to NIPA, and NIPA profits have led S&P earnings.

This is most likely driven by two factors: NIPA is less subject to accounting trickery and therefore more likely captures the underlying fundamentals. Also, there is a limit to how much large companies can diverge from the broader economy.

The US equity market is an accident waiting to happen. When the liquidity taps are turned off, a lack of underlying profits and high corporate debt, suggest US corporates will most likely be the epicenter of the next crisis. Combined with stretched valuations, it is consistent with a circa 50% fall in US equities. 

Stay informed in 2020

Stay up to date with  my latest views. Hit the FOLLOW button below to be notified by email as soon as I publish my next wire.

This wire is part of the ‘One thing investors can’t ignore in 2020’ series. To download the full ebook please click here