Margins of Error Newsletters are a wonderful thing, and I now know that subscribers are very interested in corporate earnings. So, without any mention of whether third-quarter earnings will be higher or lower than expected, I need to broach the subject again, even after going through it in detail yesterday. Thank you all for the feedback. The most important additional point to make concerns margins. These are central to the business cycle and driven by the ebbing and flowing negotiating power of capital and labor. This tends to be a reliably mean-reverting phenomenon, with rises in margins begetting a subsequent fall. It has thus long bemused relatively bearish commentators (myself included) that the margins recorded by S&P 500 companies have refused to weaken. Instead, they have ground steadily higher. If we use the National Income and Profit Accounts, or NIPA, compiled by the government statisticians who calculate GDP, we discover that margins have in fact behaved just as we might have expected, and that the business cycle turned a few years ago. This is NIPA profits as a share of GDP, in a chart produced by Torsten Slok of Deutsche Bank AG:  This chart also suggests that companies should brace for margins to fall much further as they are still at or above their peak in previous cycles before recessions. This is one of many indicators that suggest capital has indeed fared very well compared to labor over the last decade. It also suggests, however, that the capitalists who draw up corporate books are getting away with copious financial engineering and accounting sleight of hand. BCA Research Inc. compared profit margins as recorded by NIPA and by S&P 500 companies. The current divergence looks extreme. Indeed, the chart in the lower panel shows that the gap between the two versions is three standard deviations from the norm:  Note that the divergence reached four standard deviations in the other direction during the financial crisis as accountants took the chance to "throw the kitchen sink" at earnings that were bound to look bad anyway. That tends to reinforce the notion that we should treat the current strong margins with caution. BCA Research predicts that the gap is likely to be closed via a reduction in S&P margins. The Big Get Bigger One question arises from yesterday's note on the divergence between S&P 500 earnings per share and the NIPA measure of U.S. corporate profits. S&P earnings are growing far faster – but is that just because companies in the index are an unrepresentative part of the economy? If we compare earnings per share growth for the S&P 500 with the NIPA numbers, and with the EPS growth recorded for the Russell 2000 index (covering smaller companies ranked from 1,001 to 3,000 by market cap within the U.S.) and the Russell 3000 index (including all the 3,000 biggest companies, we get the following chart:  Two things are immediately apparent. First, small-cap profits have been utterly unimpressive. Since the Russell series starts in 1995, Russell 2000 earnings per share have grown more slowly than the NIPA profits – although they are narrowing the gap of late, perhaps thanks to the availability of cheap credit. Second, there is almost no difference between the Russell 3000 and the S&P 500. The biggest companies massively dominate the market. So to all intents and purposes the S&P 500 is a good proxy for the entire publicly quoted sector. That raises two interesting issues. Could the growth in S&P profits be driven by over-consolidation and monopolization, as companies exploit lower competition to extract greater margins? And is the quoted sector representative of the corporate sector as a whole? Private equity is making greater inroads, and "unicorns" are staying private while growing very large – and notoriously, in many cases, making slim or non-existent profits. Both questions are well worth asking. On competition, next month's Authers' Notes Bloomberg book club selection, The Myth of Capitalism: Monopolies and the Death of Competition by Jonathan Tepper, makes the case that much of what we see is the effect of abandoned efforts to enforce antitrust policies. Do Profits Even Matter? One seductive suggestion is that earnings don't matter any more to the stock market. In the short term, the stock market is driven almost entirely by the decisions made by central bankers. If the rates available on other investments are bad enough, and financing for the stock market is cheap enough, then share prices will continue to go up. There is something to this, of course. But if you are thinking of buying stocks it still makes sense to find out how much money the company you are buying is actually managing to make. This chart from Andrew Lapthorne of Societe Generale SA shows that earnings growth still drives relative performance of different stocks, to a surprisingly clear extent. The past 12 months have been tough for developed market stocks, but the way to limit the damage was to have a stronger earnings forecast. Stocks in the MSCI World index are divided into deciles according to the change in their earnings forecasts. And the higher the growth forecasts, the better the equity performance. The relationship isn't perfectly linear, but it is close:  And when it comes to the overall market, earnings also matter, even if the multiple investors will pay for them varies over time. This is how the S&P 500 has tracked trailing 12-month earnings per share since 1954:  The series are less closely attached since the beginning of the 1990s than they used to be. But they are still fellow travelers. If earnings decline, as looks very possible, it would be unwise to bank on further rises for the index. Like Bloomberg's Points of Return? Subscribe for unlimited access to trusted, data-based journalism in 120 countries around the world and gain expert analysis from exclusive daily newsletters, The Bloomberg Open and The Bloomberg Close. | 
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