Why stock-market bulls should be wary of rising tide of earnings shenanigans

Investors cheering stocks to all-time highs on another tide of strong earnings might be somewhat disturbed to discover the extent to which American corporations are emphasizing numbers that don’t follow accounting standards.

That’s a warning from Michael Arone, chief investment strategist at State Street Global Advisors, who noted in a paper this past week that the difference between earnings as reported under Generally Accepted Accounting Principles and nonstandard, or non-GAAP, earnings remains relatively wide compared with recent history (see chart below).

“It seems as though corporate executives are getting a bit more aggressive in their use of accounting and eliminating one-time events, and things like that, in a way to aggressively prop up their earnings,” Arone said, in a phone interview.

With the difference running nearly as wide as its been since 2007, “to me it just signals the potential that this is a red flag,” he said.

Publicly traded companies are required to issue results that comply with GAAP, but many also offer an array of supplemental, nonstandard numbers. Supporters argue the practice allows companies to offer a more accurate and nuanced picture of earnings, while critics charge that managers use nonstandard measures to obscure bad news.

Read: Here’s how investors are duped each earnings season

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See: GE’s pledge to be more accountable comes after SEC comments, stock plunge

Purported abuses of non-GAAP measures have drawn increasing scrutiny from regulators and others. As noted by MarketWatch’s Francine McKenna, the Securities and Exchange Commission earlier this month published a lengthy update to its May 2016 guidelines on nonstandard accounting metrics. The SEC last year created a task force that has sent letters to hundreds of publicly traded companies demanding explanations for items in earnings releases and on conference calls as well as other filings that were unclear or violated rules.

Also read: SEC tells companies to be careful how they talk about free cash flow

See: From a wrist slap to jail time: How the SEC deals with dodgy accounting

Check out: T-Mobile is not listening to SEC guidance on non-GAAP metrics

Arone noted that in the second quarter of 2017, 70% of companies in the Dow Jones Industrial Average DJIA, +0.14% reported results using both GAAP and non-GAAP figures. Of those companies, 80% reported higher earnings per share under the non-GAAP approach, he said.

Arone said the differences demonstrate Wall Street’s comfort with “accounting gimmicks that can exaggerate earnings strength. “When the spread gets too wide, earnings and prices are likely to fall sharply, much like what happened after 2007, he said.

See: The company that makes Jack Daniel’s is skirting accounting rules, experts say

In the paper, Arone also raises concerns about a rebounding U.S. dollar, increasingly difficult earnings comparisons, and potential threats to profit margins as labor markets continue to tighten. Arone isn’t flagging the end of the bull market and remains overweight U.S. stocks, but said with stocks at all-time highs and volatility near historic lows, “the right thing to do as an investor is to ask ...what can go wrong?”

Third-quarter earnings season, meanwhile, passed the halfway point with the past week’s torrent of corporate results. Through Friday, 55% of companies in the S&P 500 had reported results for the quarter, with 76% reporting earnings per share above estimates, surpassing the five-year average, according to FactSet. In aggregate, companies are reporting earnings that are 4.7% above estimates.

Of companies that have reported, 67% topped Wall Street sales estimate, in aggregate coming in 1.5% above consensus forecasts.

Strong earnings from tech giants Amazon.com Inc. AMZN, +13.22% , Google parent Alphabet Inc GOOG, +4.80% , Microsoft Corp. MSFT, +6.41% , and Intel Corp. INTC, +7.38% helped boost the tech-heavy Nasdaq Composite COMP, +2.20% to a 2.2% Friday rally, its biggest one-day gain since November, and a record close. The S&P 500 SPX, +0.81% saw a 0.2% weekly rise that also took it to a record finish, while the Dow industrials saw a 0.5% weekly increase.

See: Nasdaq books biggest blowout victory against Dow industrials in 15 years

Investors will have plenty of earnings to wade through in the week ahead, including results from Mondelez International Inc. MDLZ, -0.56% Apple Inc. AAPL, +3.58% Dow DuPont Inc. DWDP, -0.70% and Starbucks Corp. SBUX, -0.05%

The Federal Reserve meets Tuesday and Wednesday. No changes to monetary policy are expected, but the statement at the conclusion of the meeting will be closely watched for clues that policy makers intend to go ahead with a widely expected December rate increase.

Read: Fed statement may have treats for the hawks and the doves

Barring any weekend announcements, investors are also awaiting President Donald Trump’s decision on who will lead the Fed when Chairwoman Janet Yellen’s term expires in February. A Friday news report said Trump was leaning toward Fed Gov Jerome Powell.

The highlight on the economic calendar comes on Friday with the October jobs report. Hurricanes Irma and Harvey contributed to a fall in September payrolls of 33,000. Economists surveyed by MarketWatch forecast the data will show the economy added 300,000 jobs in October, with the unemployment rate ticking up to 4.3% from 4.2%.