In the last month, the economy gave us some particularly worrisome economic data.
Societe Generale’s Albert Edwards flags two data points: Q1 corporate profit growth, which unexpectedly turned negative, and the May ISM manufacturing report, which is now signaling a contraction in the sector.
“History tells us that this is a warning sign we ignore at our peril,” he wrote.
Edwards notes that the ISM numbers have been on the same path as they were going into the last recession.
But he believes that the ISM’s signal isn’t quite as powerful as the signal being sent by the corporate profits report. From Edwards:
The US just released its Q1 corporate profits update with the GDP data. These give a less timely but more comprehensive snapshot of what is going on with corporate profits than the S&P data. Most commentators agree the BEA data is less subject to ‘manipulation’. The Q1 data showed profits falling a tad on virtually every definition, My preferred measure is pretax economic profits of domestic non-financial companies which history suggests is a good predictor of domestic investment growth (see chart below). Profits for us are a leading indicator for corporate spending. Hence, with profits essentially flat for the last four quarters, history suggests this is not good news for the economy.
Here’s Edwards’ chart:
Societe GeneraleEdwards has subscribed to the work of John Hussman and James Montier who have argued extensively that record high profit margins are unsustainable and would inevitably revert to the mean. Profit margin contraction would translate into crumbling profits, which would ultimately take the legs out from under the stock market.
This new profits data seems to only support that thesis.
“Recent profits data published by the US Bureau of Economic Analysis (BEA) confirms our long held view that margins have been forming a peak (see chart below),” said Edwards. “Indeed it is notable that, excluding financials, profit margins have failed to break out above their usual range. As night follows day, the market should be pricing in a decline in the margin cycle from here.”
Societe GeneraleIn addition to what appears to be a peak in profit margins, revenues may be heading south to. Edwards points to the work of Ed Yardeni, which shows that S&P 500 revenue is tightly correlated with the ISM manufacturing report, which we know went negative.
“Thus we may well be in for a double dose of bad news – both falling revenues and falling margins,” writes Edwards. “History suggests this as good a leading indicator as any other for whether the US economy will endogenously fall back into recession.”
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