by jessefelder

Now we have already seen an inordinate quantity of outright fraud this cycle (see this and this) that has, thus far, confirmed to be a terrific indicator of the place we stand within the bigger market cycle. In the present day, Bloomberg studies that earnings high quality for the S&P 500 Index lately fell to its worst ranges in a minimum of three many years and this can be an necessary signal of the place we stand within the bigger financial cycle.

The way in which they quantify “earnings high quality” is to match the combination web revenue of all firms within the index (ex-financials and power) to mixture money circulate. Usually, money circulate ought to be better than earnings as a result of it provides again non-cash fees like depreciation and amortization. When that isn’t the case it may be a purple flag that firms are resorting to accounting gimmicks to make earnings look higher than they in any other case would. By inference then, firms haven’t employed “monetary shenanigans” (to borrow a time period from CFRA Founder Howard Schilit) to inflate earnings as aggressively as they’re doing in the present day at any level up to now few many years.

One other technique to strategy this challenge is to match S&P 500 Index earnings to NIPA income (tracked by the BEA). These two figures are plotted within the chart above. As Gavekal founder Charles Gave lately identified (hat tip, David Hay), “When S&P 500 income diverge dramatically from NIPA income, it’s a positive signal that accounting strategies have modified at S&P 500 firms. If S&P 500 income rise to exceed NIPA income by 20% or extra, it’s a sign that firms’ reported income are being generated largely by their accountants.”

Furthermore, there are necessary financial implications from all of this. Gave continues, “Often which means the financial system is getting ready to a recession, and that the inventory market is about to take a beating.” Final yr, we crossed that 20% threshold between S&P 500 earnings and NIPA income. Maybe we must always add this to the rising checklist of main indicators pointing to recession.