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S&P500 Operating EPS Significantly Overstates Improvements in US Corporate Profits

US equities continue to test new highs, despite ongoing geopolitical tensions on the Korean peninsula. Meanwhile, equity mutual funds continue to experience outflows as passive investment vehicles dominate funds flows from retail investors.

The riskiest components of the capital structure eventually benefitted the most from the Fed’s policy stance after Lehman Brothers’ failure. A Great Disconnect was created between vibrant risky asset prices and the real economy, while significant variation in corporate profits performance has emerged across different sectors.

The financial sector has been the biggest winner from the Fed’s post-2008 policy stance via a significant reduction in interest expenses. Banks have, however, been forced to extend asset maturities in order to boost net interest margins.

S&P500 operating EPS estimates are based on General Accepted Accounting Principles (GAAP) that have changed over time and introduced an upward bias to earnings. Meanwhile, National Income & Product Accounts (NIPA) corporate profits, based on tax accounting, have increased by a much smaller magnitude since 2009 Q2 compared to S&P500 operating EPS.

The growth differential between NIPA corporate profits and S&P500 operating EPS has increased significantly since the Great Recession in favour of the latter. The constantly changing composition of the S&P500 index goes some way in explaining the superior performance of operating EPS.

NIPA profits will adjust for write-offs when they actually happen as dictated by tax accounting rules versus being deferred until a cash reserve is established. Vibrant buyback activity by S&P500 companies has reduced the share count since 2009, thereby creating a significant tailwind for EPS growth.