The Corporate Earnings Cycle Has Just Turned Negative In The US

Submitted by Erico Matias Tavares via Sinclar & Co.,

The evolution of corporate earnings in their broadest form can provide a useful indication of the subsequent performance of the US stock markets.

This makes intuitive sense. Growing earnings are generally a reflection of good economic conditions which should be bullish for equities. The opposite also applies of course. But it is at key turning points that this indicator becomes particularly insightful, in our opinion even more than the actual level of the price-earnings ratio.

In our fundamental analysis of the market we like to look at pre-tax earnings published each quarter by the US Bureau of Economic Analysis (“BEA”), adjusted for inventories and capital consumption. This metric includes the earnings of all the companies required to file tax returns in the US (so not just the publicly-listed ones) and as such should be indicative of overall business conditions across the country. It is also a component of total national income, a major macroeconomic variable.

The following graph compares the evolution of BEA earnings and the S&P500 since 1980 (just before the start of the dramatic credit expansion in the US in recent decades):

Quarterly US Corporate Pre-tax Earnings (US$bn) and S&P500:
1Q’80 – 1Q’15

Source: BEA, Yahoo! finance.

Notice how the BEA earnings cycle (darker arrows) has a strong tendency to turn before the stock market – both to the upside and to the downside.

However, in some cases earnings turns can take place many quarters ahead of the stock market. For instance in the lead up to the crash, the earnings cycle peaked in the second quarter of 1997, while the S&P500 only peaked in the first quarter of 2000.

So in order to get a more accurate sense of the timing we have split the BEA earnings series into the dominant trend and the cycles that oscillate around it, as shown in the following graph:

Quarterly US Pre-tax Corporate Earnings (US$bn) and its Trend and Cyclical Components: 1Q’80 – 1Q’15

Source: BEA.

The red bars represent the BEA earnings cycle and the green line the dominant trend. Because cycles can vary greatly in magnitude and length, in this example we have “filtered” only those that fall within 6 and 15 years, which is actually quite a lot of time (you can still get a sense of the larger cycles just by looking at the direction of the dominant trend).

Here’s the good news for the bulls: the dominant trend remains in the upswing. The bad news is that the earnings cycle has just turned negative, as indicated by the red circle. And this could have important implications for the stock market and the economy over the coming quarters.

We did a simple analysis just to get a sense.

The following table shows quarterly periods separated in accordance with the phase of the cycle, positive or negative, as per the methodology outlined above (the red bars). To gauge whether those phase oscillations can influence equity prices, we then shorted the S&P500 each time the cycle turned negative and reversed the position as soon as it turned positive.

[NOTE: it should be emphasized that this is not meant to be a trading system (and nothing herein should be construed as trading advice). This analysis merely seeks to illustrate how the BEA earnings cycle can provide important clues about the performance of the stock market.]

In the ten alternating phases presented, this strategy would have lost money in three of them:

  • The drawdowns in two of those phases were quite significant, reaching almost a third (being short in the early days of this phenomenal bull run was clearly not a brilliant idea, irrespective of any cycle). However, in the third instance notice that we would have been short during the October 1987 crash (generating a big gain on paper), but the recovery in the following quarter ended up producing a very small loss;
  • From 1992 onwards the system got into gear, delivering a 100% win rate, with double- and even triple- digit percentage gains (although this masks some considerable paper drawdowns in the interim).

The results are actually not that bad for a stock trading system that uses a macroeconomic variable as the trigger – and on a quarterly basis no less, which has a big time lag. They could certainly be improved by adding some simple technical refinements and having a quicker reaction time, but that’s beside the point.

What we have seen is that a broader measure of corporate earnings can give investors a useful long or short bias for the stock markets and the economy over the medium-term. And for the first time since the end of the Great Recession that bias has turned negative.

This does not mean that you should sell everything and run for the hills. However, we should also not disregard the deterioration of a key fundamental driver of the market.

If anything, what does this tell you about the odds of continuation of the bull market over the coming quarters?