Why Corporate Profits Could Be Weaker Than They Seem

Summary

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WSJ Your Money Briefing

Episode: Why Corporate Profits Could Be Weaker Than They Seem
Date: June 1, 2018
Host: J.R. Whalen
Guest: Justin Lahart, Heard on the Street Columnist

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Episode Overview

This episode explores the apparent disconnect between strong first-quarter corporate profit reports from S&P 500 companies and surprisingly flat profit numbers from the U.S. government. J.R. Whalen and Justin Lahart break down the reasons behind these opposing views, discuss the impact of the recent tax cuts, and consider what these trends could mean for savvy investors and the future of the stock market.

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Key Discussion Points & Insights

1. Divergence in Profit Reports

Time: 02:38–04:13

• S&P 500 vs. Government Data:
  • S&P 500 companies reported an average profit increase of over 26%, while government data showed profits were nearly flat.
  • Justin Lahart explains:

    “The data are a little bit different when you look at S&P 500 companies... they're multinationals... The government numbers are just for profits from U.S. production.” (02:38)

  • S&P 500 profits often exclude one-time charges to present a more favorable picture, whereas government figures include such items for a more comprehensive view.
  • Government reports focus solely on profits generated within the United States, ignoring overseas operations, while S&P 500 data cover global activities.

2. The Tax Cut’s Role

Time: 04:14–05:07

• Tax Cut Effects:
  • Both S&P 500 and government numbers reflect benefits from recent tax cuts, though the magnitude is seen more in S&P 500 reporting.
  • Lahart highlights the impact of looking at “before tax” profits:

    “Before tax profits, those were actually down 6% from a year ago. It gives you an idea of...how much the tax cut has boosted results.” (04:37)

  • The surge in reported net profits is attributed more to lower taxes than to actual growth in business operations.

3. Wall Street’s Perspective and Market Realities

Time: 05:08–05:59

• Stock Market’s Tepid Response:

  • Despite better-than-expected reported profits, stock performance has been subdued.
  • Lahart observes:

    “You would have thought with great earnings that you would have seen stocks do really well, but stocks haven’t done really well lately. They've just kind of muddled along.” (05:13)

  • Market behavior suggests investors may be more aligned with the government’s more cautious profit outlook.

• Peak Profits and Investor Strategy:

  • Government data indicates corporate profits may have peaked, making the environment more challenging for markets.
  • Lahart:

    “When you’re past peak on corporate profits, things can get a little more challenging for the stock market.” (05:42)

4. Wider Economic and Investment Implications

Time: 05:59–06:46

• Rising Costs and Profit Challenges:

  • J.R. Whalen notes the role of increasing labor and other costs in pressuring profits.
  • Lahart explains:

    “As you get further along in the profit cycle, we see costs go up... The challenge is to find the companies that are able to keep profit growth going.” (06:02)

  • The market may increasingly reward those select firms that can sustain growth despite rising costs, creating a “haves and have-nots” dynamic.

• Long-term Uncertainty Post Tax Cut:

  • The longer-term impact of tax cuts on both profitability and the broader economy remains uncertain.
  • Lahart outlines possible scenarios:

    “If companies, you know, people have a lot more money to spend. Employment continues to do better. Maybe wages go up, maybe there's more investment in productive assets... If the economy started doing a lot better over the next year... that would translate into higher sales and that would be good for companies and good for profits.” (06:56)

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Notable Quotes

• On the Data Discrepancy:

  “It's interesting that we've seen this big discrepancy between what the S&P 500 companies are saying and what the government is saying. Because this discrepancy wasn't there a couple of quarters ago.”
  — Justin Lahart (03:28)

• On Wall Street Sentiment:

  “You would have thought with great earnings that you would have seen stocks do really well, but stocks haven’t done really well lately. They've just kind of muddled along.”
  — Justin Lahart (05:13)

• On Investors’ Challenge:

  “For investors, the challenge is to find the companies that are able to keep profit growth going. So it becomes a real sort of haves and have-nots situation in the stock market.”
  — Justin Lahart (06:04)

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Timeline of Important Segments

• 02:38 – Discrepancy between S&P 500 and government profit numbers explained
• 04:13 – The impact of tax cuts on corporate profits
• 05:07 – Market reaction and implications for stock performance
• 05:59 – Investor challenges amid rising costs
• 06:46 – The uncertain future and potential long-term effects of the tax cut

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Summary

The episode delivers a nuanced view of corporate profit reporting, revealing that headline gains may be more the result of tax policy than underlying business strength. Wall Street appears to be cautious, signaling that investors are watching beyond accounting earnings to whether real profit growth is sustainable in the face of rising costs and waning tax-cut effects. The conversation underscores the importance of understanding different data sources and the underlying forces moving markets, with an eye toward the possibility that the best days of this profit cycle may already be behind us.

Transcript

[A]

This episode is brought to you by Charles Schwab. Decisions made in Washington can affect your portfolio every day. Washington Wise from Charles Schwab is an original podcast that unpacks the stories making news in Washington. [e-mail] Washingtonwise your money briefing Money in

[B]

Market stories from the Wall street journal. I'm J.R. whelan in New York. At first glance, the first quarter was strong for corporate profits. But coming up, we'll explain why. A second glance may be needed to bring the full story into focus. First, these money headlines. Despite what seemed like unending market volatility and gyrating reactions to ongoing tariff threats, May was an upbeat month for the major stock indexes. The Dow Jones Industrials finished the month up just a hair over 2%. Meantime, the NASDAQ Composite registered a 5% gain for the month, and the S&P 500 turned in a roughly 2.9% gain. The National Federation of Independent Business Employment Survey indicates the number of small businesses raising wages hit a record high in May. In the U.S. 35% of owners of small firms report increasing labor compensation. That's the highest percentage since the federation started asking businesses about that in 1986. The survey also finds that 23% of business owners now cite the difficulty of finding qualified workers. And as their single biggest challenge, JPMorgan Chase CEO Jamie Dimon is the highest paid banking and finance chief executive in the S&P 500. Dimon has run the bank since late 2005 and made $28.3 million in 2017. That's up 4% from 27.2 million a year earlier. The median pay for the 43 banking and financial CEOs in the Wall Street Journal's analysis was $12.1 million. That matches median pay for the S&P 500 as a whole. The top spot in the list is familiar territory for Dimon. He's ranked as the highest paid among the group of 43 banking and financial CEOs in three of the past four years. The 62 year old said in January he plans to run the bank for another five years. This is your Money briefing from the Wall Street Journal. Welcome back, everybody. You've heard the saying things aren't always what they seem. Well, that could apply to corporate profits reported in the first and heard on the Street. Columnist Justin lehart is here to explain. So, Justin, measuring the strength of first quarter corporate profits essentially comes down to who you ask. S&P 500 company data indicates profits rose on average, more than 26%. But the government says profits were nearly flat. How can there be such a steep discrepancy?

[C]

Yeah, so the data are a little bit different when you look at S&P 500 companies. Right. That is profits, you know, earned all over the place for these big companies. Right. So they're multinationals. They make money in Europe, they make money in Asia and they make most of their money here, but still they make a lot of money overseas. There are also, you know, another thing that happens with these S&P 500 companies is a lot of times the profits they report, sort of the profits that they want people to use exclude a lot of one time charges. They say, well, you know, that was not a normal part of business, so we're going to exclude that. And that's something. So the government also does probably profit numbers and they're a little bit different. First thing, they don't exclude all of those charges. And also it's for profits from just US production. So mostly what's being earned here. So there's a little bit of a different definition there. But it is interesting that we've seen this big discrepancy between what The S&P 500 companies are saying and what the government is saying. Because this discrepancy wasn't there a couple of quarters ago.

[B]

So if a company has operations throughout the world, it's just the US operation that the government tends to put into its numbers.

[C]

Yeah, just that. So it needs to be. It's economic data, it's about the US economy, it's about what's being produced here. So if you produce something and then send it abroad, that counts. Right. But if you have a factory in Europe making cars, that doesn't count.

[B]

All right. And the tax cut has a lot to do with the numbers being reported also.

[C]

Well, we see the tax cut effect in both instances. So one reason The S&P 500 numbers are up so much is because of this tax cut. We also see it in the government numbers. What's handy about the government numbers is that they also give a. The government also gives a before tax profit figure. So if you look at before tax profits, Those were actually down 6% from a year ago. It gives you an idea of sort of the scope of how much the tax cut has boosted results. And also it's important to, you know, if you're thinking just about the profitability of the operations, you want to be able to account for that tax cut somehow.

[B]

You say in your column that it seems that Wall street is siding with the government on this. When it comes to the discrepancy. When you look at stock performance, the

[C]

first quarter was a big surprise. On the upside, when it comes to profits, we're really much better than analysts had expected. A lot of that came down to the tax cut that they hadn't maybe properly accounted for how much of a boost the tax cut would give. It's very interesting because the stock market, you would have thought with great earnings that you would have seen stocks do really well, but stocks haven't done really well lately. They've just kind of muddled along. One thing that you're seeing in the government's data is it looks like we're past peak on corporate profits. When you're past peak on corporate profits, things can get a little more challenging for the stock market.

[B]

And if profits are in fact weakening, it would make sense given the higher costs of labor and other items that come into play.

[C]

Right. That's typically what happens as you get further along in the profit cycle. We see costs go up. And then for investors, the challenge is to find the companies that are able to keep profit growth going. So it becomes a real sort of haves and haves nots situation in the stock market. It's not sort of the death knell for the stock market, but it's just a lot of times investors in that situation will gravitate towards these companies that can keep on delivering growth even as costs are rising.

[B]

But there's a bit of an unknown looking ahead. We're only talking about one quarter's worth of data here. We don't know the longer term impact of the tax cut on companies. And investors should really pay attention.

[C]

Yeah, we really don't know what's going to happen with the tax cut in terms of the economy. Right. So if companies, you know, people have a lot more money to spend. Employment continues, continues to do better. Maybe wages go up, maybe there's more investment in productive assets. Right. Those are all good things for the economy. So ultimately, if the economy started doing a lot better over the next year. Right. Then that would, that would translate into higher sales and that would be good for companies and good for profits.

[B]

All right, that's Wall Street Journal heard on the Street. Columnist Justin lehart joining us here in our studio. Justin, thanks for being with us.

[C]

Thank you.

[B]

And that's your money briefing. I'm JR Whalen in New York for the Wall Street Journal.

[A]

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