Since the vast majority of business cash flow is derived through profits, the basis for the declining cash flow incidence resides within the profit function of US business. Since there are multiple avenues to arrive at aggregate profit estimates, there is the potential for disagreement as to the assumed health of net income across domestic business. The primary complication is usually inventory, as the BEA tries to figure out how much profit is derived simply by the change in prices of inventory stock held across time. However, in more recent years tax law has driven accelerated depreciation leading to a larger discrepancy there.
Given contemporary behavior regarding inventory, there is no surprise that it would be an enlarged factored difference between After Tax Profits with and without IVA (removing inventory valuation) and CCadj (adjusting depreciation from a tax basis). Corporate After Tax Profits with both the IVA and CCadj are known as “economic profits” due to their derivations – the purest form of profitability derived from engaging in actual business rather than accounting convention.
Profits on the assumed economic basis, with all the adjustments, fell rather deeply in the first quarter. Further, as much as financial firms’ collective difficulties are a major factor, it was not limited to FICC revenue at the big banks. Nonfinancial profits also declined, as did profits resulting from overseas trade with the Rest of World.
The trend in “economic profits” has been lower for quite some time now, matching the diminishing pattern and trend in net cash flow.
Since the change in rate for “economic profit” matches closely with economic cycles, this is another indication as to being closer to the end of the upswing in the cycle than the beginning (the only exception being the near-recession in 1987 and the near-recession during the mania of the dot-coms in 1999 that eventually turned once the bubble faded). The role of inventory buildups preceding recession is also clear, as firms accumulate too much at the end of a cycle – which, somewhat ironically, actually boosts their unadjusted profit estimate. That is the impetus behind taking the IVA out of the equation and arriving at the economic basis for business behavior.
There is little mystery as to why the latest quarterly update featured so large a difference in profit measures. The level of inventory growth in the past few quarters is simply unprecedented, so too would be the difference between profits with and without IVA. Now that accelerated depreciation is being phased out as a “stimulus” (another tax trick that worked so well for capex), the CCadj part will also continue to contribute to the dichotomy for some time. In any case, the “economic profits” estimate seems to match very closely to observations in the real world.
We know that profit growth, real profit growth rather than non-GAAP, from traded companies has slowed pretty much alongside the rate of growth in “economic profits.” Beside that perhaps the most striking confirmation of this is the small caps. I noted at the end of April the calculated “EPS” for the Russell 2000 was about $11, yielding a PE then of 101.65. That EPS figure compared to about $27 only a year prior and certainly suggests, strongly, that profit growth in smaller businesses, more susceptible to cycle changes, are experiencing far more difficulty than just cold weather.
Since then, the estimated EPS for the Russell 2000 has come up, but only to about $13. Any improvement with the temperature rising has thus been exceedingly modest, certainly far less than anticipated.
In any case, this profit element from both sides adds another layer to the cash flow and debt trends that I believe show a very tired and aged economy far more than one set for “this is finally it.”
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