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This S&P 500 "Profits Gap" Is a Warning to Stock Market Investors

By Alex Dumortier, CFA – Mar 22, 2016 at 11:39AM

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The gap between companies' adjusted earnings and earnings based on GAAP is at a worrying level.

Image source: LendingMemo, republished under CC BY 2.0.

Unsurprisingly, given the tragic events in Brussels today, global equity markets are lower on Tuesday. The U.S. is no exception, with the S&P 500 (^GSPC 0.89%) and the Dow Jones Industrial Average (^DJI 1.20%) (DJINDICES: $INDU) down 0.01% and 0.09%, respectively, at 11:30 a.m. ET. However, the impact of this terrorist attack on the U.S. stock market is likely to be minor and short-lived.

On a longer-term timeframe, one of the fundamental drivers of stock market returns is, of course, corporate earnings. On that front, the impressively widening gap between companies' adjusted earnings and conforming earnings is an unfavorable signal.

These are the hard numbers.

For the last 12 months, according to Evercore ISI (part of investment bank Evercore Partners), companies in the S&P 500 have reported adjusted earnings that are 30% higher than the earnings based on generally accepted accounting principles (GAAP). Companies have a lot more discretion in calculating adjusted earnings, and these usually exclude "exceptional" items such as one-time charges.

That difference between adjusted and GAAP earnings is the widest it has been for any 12-month period since 2008, and the third-largest in ISI Evercore's time series, which starts in 1995.

It's not particularly encouraging that the two previous peaks, in 2008 and 2002, occurred during or just after a recession:

  • The Great Recession, which spanned December 2007 to June 2009.
  • The short recession that followed the bursting of the technology bubble (March 2001 to November 2001).

Furthermore, there is a cogent rationale to explain this link. As Pankaj Patel, Evercore ISI's head of quantitative research told the Financial Times, "[the gap between adjusted and GAAP earnings] tends to rise when companies start making one-time exceptions and special items, and companies typically resort to these extreme measures when profitability starts taking a hit."

The trouble, according to another quantitative analyst, Andrew Lapthorne of Societe Generale, is that GAAP earnings are a more realistic measure of corporate profits (he dubs pro forma profits "made-up profits"); in the long run, then, they matter more.

It can be no coincidence that Nobel Prize-winning economist Robert Shiller opted to use GAAP earnings in calculating the cyclically adjusted price-to-earnings ratio (the CAPE, or "Shiller PE"), which is thought to be the best measure of long-term value.

It's worth noting that in each of the three periods in which the gap between adjusted and GAAP profits peaked, the widening was largely driven by the collapse in GAAP earnings in one specific sector: Technology in 2001/ 2002, Financials in 2008, and Energy in 2015.

Does the current "earnings gap" indicate that a recession is imminent? It's difficult to say, but it may be symptomatic of an aging bull market in which stock market gains -- certainly on the pace we've known since March 2009 -- will be hard to come by.

Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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