by jessefelder

We’ve got already seen an inordinate quantity of outright fraud this cycle (see this and this) that has, up to now, confirmed to be a terrific indicator of the place we stand within the bigger market cycle. Right now, Bloomberg reviews that earnings high quality for the S&P 500 Index just lately fell to its worst ranges in at the least 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 mixture internet earnings of all corporations within the index (ex-financials and power) to combination money move. Usually, money move needs to be larger than earnings as a result of it provides again non-cash expenses like depreciation and amortization. When that isn’t the case it may be a crimson flag that corporations are resorting to accounting gimmicks to make earnings look higher than they in any other case would. By inference then, corporations haven’t employed “monetary shenanigans” (to borrow a time period from CFRA Founder Howard Schilit) to inflate earnings as aggressively as they’re doing immediately at any level prior to now few many years.

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

Furthermore, there are necessary financial implications from all of this. Gave continues, “Often which means that the financial system is getting ready to a recession, and that the inventory market is about to take a beating.” Final 12 months, we crossed that 20% threshold between S&P 500 earnings and NIPA earnings. Maybe we should always add this to the growing list of main indicators pointing to recession.