Record decline in GDP has quickly become a consensus forecast. But the question now is how big of a drop in operating profits should investors expect?
This historic collapse in business revenue, along with record capital losses, could trigger an unprecedented decline in operating profits. Only once before, in Q4 2008, did overall S&P 500 operating profits post an outright decline.
A collapse in profits, with record debt levels, raises the prospect of liquidity concerns and a litany of credit downgrades. Until corporate debt risks subside rallies in the equity market will be limited, and can quickly reverse.
S&P 500 Operating Profits
Companies use a financial accounting framework to report their operating results. This measure differs in several ways from the tax accounting measure that is used to estimate profits in the GDP accounts.
One of the biggest differences between the two accounting frameworks is that financial accounting allows companies to include capital income gains and losses, whereas the GDP measure excludes income from the revaluation or sale of an asset.
The Bureau of Economic Analysis (BEA) periodically does a reconciliation of the two measures of operating profits. Unfortunately, the last report was issued March 2011 and a senior official at BEA said the next report is not scheduled until later this year or early 2021.
Drawing on past reports, the largest difference between the two measures is capital gains, net of losses. This single item can amount to hundreds of billions in any given year, and by itself explain much of the difference in the growth rates of the two operating profits measurements.
During the five-year period that ended in 2019, the GDP measure of operating profits was essentially flat, but S&P 500 operating profits increased +30%. Since S&P 500 equity prices posted a +50% gain over this five-year period it appears that companies booked capital gain income to boost their financial results.
In early 2020, S&P 500 companies are facing a double punch; record plunge in GDP and huge capital losses.
In Q4 2008, S&P 500 profits posted the worst performance in the post-war period, recording a -$3.2 billion decline. This was a massive drop from the $557 billion profit made in the prior quarter. A record -8.4% annualized decline in real GDP, and -22.5% decline in the S&P 500 equity index triggered the plunge in reported profits. In 2020 profits are coming off a much higher level; S&P 500 profits totaled nearly $1.3 trillion in Q4 2019, so this tumble is going to be drastic.