:::: Better Sales And Profit Growth Are Behind Good 1Q17 Results, Not Financial Engineering By Urban Carmel | May 5, 2017
Summary: S&P profits are up 22% yoy. Sales are 7.2% higher. By some measures, profit margins are at new highs. This is in stark contrast from a year ago, when profits had declined by 15% and most investors expected a recession and a new bear market to be underway.
Bearish pundits continue to repeat claims that are more than 20 years old: that "operating earnings" are deviating more than usual from GAAP measurements, and that share reductions (buybacks) are behind most EPS growth. These are both wrong. Continued growth in employment, wages and consumption tell us that corporate financial results should be improving, as they have in fact done.
Where critics have a valid point is valuation: even excluding energy, the S&P is now more highly valued than anytime outside of the 1998-2000 dot com bubble. With economic growth of 4-5% (nominal), it will likely take excessive bullishness among investors to propel S&P price appreciation at a significantly faster rate.
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A little over 60% of the companies in the S&P 500 have released their 1Q17 financial reports. The headline numbers are good. Overall sales are 7.2% higher than a year ago, the best annual rate of growth in more than 6 years. Earnings (GAAP-basis) are 22% higher than a year ago. Profit margins are back to their highs of nearly 10% first reached in 2014.
Before looking at the details of the current reports, it's worth addressing some common misconceptions regularly cited by bearish pundits.
First, are earnings reports meaningfully manipulated? This concern has been echoed by none other than the chief accountant of the SEC, who has complained about non-GAAP earnings numbers being "EBS", or "everything but bad stuff."
Here's the catch: this quote is not new, it was made nearly 20 years ago as the 1990's bull market was ending. A version of the complaint that financial reports are fake has been a feature of every bull market.
Now, it's true that "operating earnings" (blue line) both overstate and smooth profits compared earnings based on GAAP (red line). But that has been the case over the past several decades; more importantly, the trend in earnings is clearly the same regardless of methodology (all financial data in this post is from S&P).
In fact, the difference between operating and GAAP earnings in 1Q17 was about 10%, which is normal (i.e., it equals the 25-year median). Operating earnings overstated profits by much more in the 1990s and earlier in the current bull market. The biggest differences have always been during bear markets. In short, recent deviations from GAAP are unremarkable when compared to history. . .
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