The Evolution of Profit Recessions
Looking back at history, profit recessions—defined as at least two quarters of consecutive negative earnings growth—typically accompany economic recessions. This shouldn’t come as a surprise. Historically, the biggest determinant of earnings growth is revenue growth, which is a function of economic growth. Put differently, what’s happening in the real economy trumps other factors impacting profits, such as changes in margins. (Where To Look With Low Earnings)
The importance of economic growth for corporate profitability is evident when looking back at over 60 years of National Economic Accounts corporate profits data. Over the past sixty years, quarterly changes in real gross domestic product (GDP) explain roughly 30 percent of the variance in quarterly profits growth, according to the government data accessible via Bloomberg.
Given this relationship, in the absence of an economic recession, how are we in a profit recession? The reason is that there have been exceptions, periods when the economy expanded but corporate profits temporarily fell. Unfortunately, those periods have coincided with two trends that are also evident today: a stronger dollar and lower oil prices.
The most recent example was in 1998, when despite a stellar economy, corporate profits fell. Similar to today, a strong dollar was partly to blame. From the summer of 1996 through the summer of 1998, the Dollar Index appreciated roughly 20 percent, according to Bloomberg. The rapid appreciation of the dollar put a squeeze on U.S. exporters, hurting corporate profits.
In contrast, the profit recession of 1986 occurred coincident to a period of dollar weakness. In 1985 the dollar started a long-term decline following the Plaza Accord, signed in September of that year. But while the U.S. currency was not a headwind, a collapse in oil prices contributed to the 1986 profit recession. WTI crude fell from over $30/barrel in the spring of 1984 to just over $10/barrel by July of 1986, as figures via Bloomberg show.
What do these historical incidents suggest about the current situation? While the U.S. is likely experiencing a profit recession, or at least a profit drought, it shouldn’t be long or deep absent a full-blown recession. Assuming U.S. economic growth remains positive, a technical profit recession is unlikely to last more than a few quarters.
Further dollar appreciation will probably be more muted and slower than it was earlier this year, given U.S. growth is on a lower-than-expected trajectory and the Federal Reserve (Fed) is likely to be particularly timid in raising rates.
As for oil, I believe oil prices have probably bottomed, with the negative impact of lower prices likely to fall out of energy company earnings by the first quarter of next year. Also, with the weight of energy companies in the S&P 500 down to roughly 7 percent, about half of the level in early 2011, according to Bloomberg data, energy prices shouldn’t impact the broad market as much as they have in the past. (Technical Signals Oil Has Bottomed)
Where Investors Can Go From Here
So, investors should look past this temporary profit drought and focus on the real economy. How the U.S. economy fares in 2016 will be key for determining whether or not the current profit blip is simply an interruption in the long-term bull market or the beginning of the end.