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Recession Alert? Corporate Giants Are Massaging Their Earnings

<br> (via Bloomberg)

Recessions are rare — or, at least, government statistical bureaus are slow to recognize them. But big corporations don’t take chances. They work hard to avert an earnings recession, usually defined as two consecutive quarters of profit decline.

Looking at S&P 500 companies’ earnings, it doesn’t feel like an economic downturn is on the horizon, even as worries about a global economic slump mount. These large companies may be more resilient, with their currency hedging tools and diversified businesses, one could argue. 

Or perhaps there’s some “creative accounting” at work, suggests Gavekal Research’s Charles Gave, who started his finance career in 1970. He compared S&P 500 earnings to profits from the broader economy and found that, historically, the two data series diverge on the brink of recessions.

In fact, this profit divergence may be an even better recession predictor than an inverted Treasury yield curve. Since 1960, on every occasion when S&P 500 earnings climbed at least 20% above broader corporate profits, a recession ensued, notes Gave. We are seeing this divide again. 

Here’s the logic: As business conditions worsen, big publicly traded companies find it harder to generate profits that would please Wall Street. So their accountants come to the rescue. But accounting magic has its limits, so their earnings inevitably drop, causing the two data series to converge again.

I find Gave’s explanation plausible. Here’s a concrete example, played out in Asia. In August, SoftBank Group Corp. said it cut its exposure in Alibaba Group Holding Ltd.’s shares to 14.6% from 23.7%. As a result, it expected to record about 2.4 trillion yen ($16.6 billion) in gains from the revaluation of its remaining Alibaba stake.

That would be a welcome cushion. In the first half this year, SoftBank incurred record losses from the poor performance at its two Vision Funds. 

In this case, there was no cash inflow; the only tweak involved the accounting treatment. Now that SoftBank owned less than 20% of Alibaba, the Chinese e-commerce giant no longer needed to enter SoftBank’s financial statements as an associate. As a result, SoftBank can be treated as a passive investor, thereby allowing it to record unrealized mark-to-market capital gains that it couldn’t do previously.  

This perhaps explains why equity strategists are pessimistic on stocks. The S&P’s price-to-earnings ratio still embeds “a completely misplaced equity-risk premium given the rising risk to earnings,” noted Morgan Stanley this week. How reliable are the earnings we see?

Already, large companies are revising their guidance at a faster pace than last year. All it takes is a few more profit warnings from global business leaders such as FedEx Corp., and the big corporates’ big profit facade will come crashing down.

More From Bloomberg Opinion:

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• Why Investors Are Facing Even More Instability: Mohamed El-Erian

• What Comes After a Week That Shook the World: John Authers

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. A former investment banker, she was a markets reporter for Barron’s. She is a CFA charterholder.

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