Ultimately, the value of any security is the properly discounted stream of cash flows that the security will deliver into the hands of investors over time. It is very convenient for Wall Street to operate on the basis of "operating earnings" - which aren't even defined under Generally Accepted Accounting Principles (GAAP) - because this measure of earnings is detached from any need to properly deal with portions of earnings that are lost to writeoffs, "extraordinary" losses, option grants to insiders, and so forth. Yes, these items appear in net earnings, but to most analysts, it is apparently unimportant if companies repeatedly write off previously reported "earnings" as losses, or quietly divert them to incentive compensation - all of that is water under the bridge even if it occurs quarterly.
Still, net earnings represent the only amounts that investors can hope to obtain, and then only if the net earnings are distributed as dividends or invested in productive activities that don't get written off later. It's those net earnings that go into the calculation of Shiller's cyclically-adjusted P/E (CAPE), and the results are not kind here.
A couple of weeks ago, I was in a CNBC segment discussing economic conditions. I decline the vast majority of media requests, but I thought it was important to talk about the economic risks we're observing. It was a debate-style format with another analyst who essentially recapped the same arguments that he made at the 2007 market peak. Indeed, just before the market plunged by more than half, he asserted "the fundamental underpinnings of stocks are superb." He later appeared on CNBC in January 2008 sporting a beard, asserting that all of the recession talk was overblown, and telling a reporter at TheStreet that he would not shave the beard "until the recession talk ends or housing recovers, whichever comes first." As of a couple of weeks ago, he had no beard, which was perplexing.
Now, while I have difficulty with analysts who repeatedly lead investors down the primrose path to abominable losses, my defensive approach has also left enough on the table from time to time that I don't want to throw stones. Still, one feature of his analyst's argument was different from 2007, and the more I've thought about it, the more I realize how damaging it could be to investors, so I think it's important to discuss. Specifically, instead of using forward operating earnings to assert that stocks were cheap, he based his valuation assessment this time on NIPA profits (from quarterly GDP accounting). Quoting NIPA profits in the context of market valuations struck me as odd, but the segment immediately jumped to another question. Part of the reason I don't do much TV. You can't thoughtfully discuss the financial markets in 20-second sound bites.
Here are the basics. NIPA profits (from the National Income and Product Accounts, compiled by the Bureau of Economic Analysis) are a quarterly measure of economy-wide profits, restricted to current production, less associated expenses. As economists at the Department of Commerce and the BEA have noted (Mead, Moulton and Petrick, 2004), this measure of earnings deviates substantially from S&P 500 earnings. Expenses used in the calculation of NIPA profits exclude bad debts, resource depletion, disposition of assets and liabilities, capital losses, and any deductions relating to the treatment of employee stock options. It also includes an allowance for misreporting of corporate income. Many of these calculations are only available on an annual basis, with a considerable lag, and as a result, quarterly NIPA profit estimates and revisions make significant use of interpolation and extrapolation.
Moreover, the NIPA estimate deviates from S&P 500 earnings not only because it excludes all sorts of expenses that are relevant to shareholders, but also because it covers the entire universe of U.S. companies, including small businesses, Sub-S corporations, and mid-sized companies that are not in the S&P 500. Indeed, S&P 500 earnings as a share of NIPA profits have fluctuated between 38% and 85% over the past couple of decades. Except for a slight amount of predictable mean reversion when S&P 500 net income declines during recessions, there is no correlation at all between divergences between NIPA profits and S&P 500 earnings (net or operating) and subsequent changes in S&P 500 earnings. So they aren't reliably predictive of anything.
In short, the NIPA profit estimate is a frequently revised, noise-ridden, extrapolation-based quarterly data point, reported with a substantial lag, that excludes a host of shareholder-relevant expenses, and covers a broadly different universe of companies than does the S&P 500. So I've been asking myself, why would anyone want to use NIPA profits to value the market, instead of using actual earnings reports, or even forward operating earnings which are already a sufficiently overblown measure of corporate performance? The only answer I can come up with is that NIPA profits are an even more overblown and misleading measure, allowing the continued assertion that stocks are undervalued.
