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Economy in Brief

"Solving" The Profits Puzzle
by Joseph G. Carson ([email protected])  September 30, 2019

The profits puzzle is no more. A recent report by the Bureau of Economic Analysis (BEA) stated that the primary reason that the GDP measure of operating profits does not show the "large run-up in profits" in other "popular measures" (e.g., S&P profits) is because it does not include capital gains, while other measures do. And it’s happening again.

BEA periodically publishes a report that provides a "conceptual bridge" to gauge the differences between the growth rates of the GDP measure of profits and S&P 500 reported profits.

According to BEA there are several accounting principles that affect measures of receipts and expenses and their timing, and "comparisons can be meaningful" with GDP & S&P 500 operating profits only if adjustments are made for the differences.

The adjustments fall into two broad categories: capital gains (net of losses) and bad debt expenses. Trading gains and losses are considered part of S&P 500 operating profits, but not part of GDP profits since they reflect a change (gain or loss) in the valuation of existing asset. Also, bad debt expenses are included in the GDP measure of profits since these reflect an adjustment to corporate balance sheet, while the write-down of existing assets are excluded from S&P 500 profits.

In past reports, BEA has published a series on GDP profits (after tax) and then an adjusted GDP profit series, netting out the bad debt expenses and adding back the capital gains (net of losses) in order to make the GDP profit series more aligned with the financial accounting basis for S&P profits.

According to the data published by BEA, capital gains (net of losses) run about 3 times larger than bad debt expenses during periods of economic growth and rising asset markets. But during periods slow growth or recession and falling risk markets capital gains (net of losses) can run equal to or even below bad debt expenses. Also, capital gains (net of losses) can ran as high as 30% of GDP measure of profits during rising risk markets.

Yet, it’s the "growth rates" that BEA believes offer the most meaningful insight when assessing the differences between adjusted GDP and S&P profits measures. And the differences in growth rates can be quite substantial, and in some cases the profit series move in opposite directions.

For example, in 2000 during the peak of tech bubble S&P operating earnings showed a double-digit gain in earnings, while the adjusted GDP measure of profits posted a decline. And in 2008 (financial crisis) the S&P operating profit declines was substantially larger than the GDP adjusted measure.

A senior BEA official said the next reconciliation report on GDP and S&P 500 profits would not be released until late 2020. Nevertheless, its already been well documented that capital gains are the key "wedge" between GDP and S&P profits and represent the most likely source of 2014 to 2019 outperformance of S&P 500 operating earnings. And its also important to note that while capital gains provide an extra boost to the growth rate of S&P 500 operating profits during rising risk markets they also represent a huge drag during down markets.

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