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Winner-Take-All Bloat May Preserve Huge S&P 500 Profit Advantage

Sarah Ponczek
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Winner-Take-All Bloat May Preserve Huge S&P 500 Profit Advantage

(Bloomberg) -- A chart that shows a widening divergence between earnings in the S&P 500 and the rest of the economy may be explainable without concluding the stock market is about to collapse.

So says JPMorgan Chase in a note titled “Another take on the S&P-NIPA profit gap,” which examines the expanding gulf between income reported by the biggest U.S. public companies and a broader swath of businesses. While the imbalance gets held up as evidence megacap executives are taking bookkeeping liberties they’ll one day pay for, the bank says there may be other reasons S&P 500 firms earn so much more than everyone else.

The analysis may be good news for the bull market, though it’s unlikely to calm concerns about wealth inequality and employment. Broadly, JPMorgan hypothesizes that profits are ballooning at giant companies not because of accounting sleight-of-hand, but due to monopoly-like concentration, particularly when it comes to paying people.

“There’s been talk over the past few years really about the differences between what the true earnings are as opposed to what companies are reporting with all the adjustments,” Sameer Samana, senior global market strategist for Wells Fargo Investment Institute, said by phone. “You’ve got to at least try to ask yourself, ‘Well, why is that?”’

At the center of the debate are two sets of books that broadly measure the profitability of U.S. businesses. One is a survey known as the national income and profit accounts, or NIPA, compiled by the Bureau of Economic Analysis and spanning public and private firms. The other are the results being reported to investors this week: financial earnings published quarterly by public firms.

Right now, the data paint different pictures. While the steep ascent of profits at public companies is frequently cited as justification for a bull market which has lifted the S&P 500 more than 100% since the start of 2013, profits in the NIPA presentation have barely budged over that period. Earnings for S&P 500 companies have risen over 50% in the last six years, according to Bloomberg data, while government data shows NIPA profits haven’t risen 10%.

Generally, stricter accounting standards employed in the NIPA data are cited for the disparity. That raising speculation bigger companies are padding their accounts by letting investment gains and other non-core benefits run to the bottom line -- and will eventually face a reckoning.

It may not be that dramatic, JPMorgan says. Analysts at the bank see the pressure on profits in the NIPA survey as mainly attributable to rising labor costs, and say that as industries have grown more concentrated, bigger companies have suffered less from that squeeze. The bank’s data show the same industries that have seen the most concentration have also seen the share of their sales that go to labor costs fall the most.

“The top four firms in each industry are likely to be in the S&P 500, and may be better-positioned to resist the latest increases in unit labor costs,” Michael Feroli, chief U.S. economist for JPMorgan Chase & Co., wrote in a note this week.

As year-over-year wage gains accelerated above 3%, the Federal Reserve’s preferred measure of price pressures has remained relatively muted, with core personal consumption expenditures (PCE) struggling to meet the central bank’s 2% target. This may be why overall NIPA profits have been squeezed, according to JPMorgan, as unit labor costs are growing faster than business output prices.

Another reason to cite smaller and private companies in the disparity is comparable profit margins, as small caps have seen them narrow more. Feroli compares S&P 500 margins with an equivalent reading for the S&P Small Cap 600 Index. While margins for large caps have been trending higher, small-cap margins are near their lowest levels of the bull market.

“The NIPA and S&P 500 margin disconnect may be one of coverage,” Michael Feroli, chief U.S. economist for JPMorgan Chase & Co., wrote in a note this week. “Namely that it is smaller corporations -- both small publicly traded and other non-publicly traded corporations -- that are experiencing more of a margin squeeze.”

Still, JPMorgan’s Feroli acknowledges that the data that would confirm such a thesis (business spending and hiring by firm size) is unavailable or operates with a lag. In the meantime, he points to ADP employment figures which signal small- and medium-sized companies are to blame for this year’s hiring slowdown.

“Our claim that the squeeze in profit margins is more tilted toward smaller firms is tentative,” Feroli says.

To contact the reporter on this story: Sarah Ponczek in New York at sponczek2@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Chris Nagi

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