GAAP vs Non-GAAP Earnings? Should Investors Care?

The S&P 500 Index has rebounded 13.2% since the February 11th intra-day low of 1,810.10. Friday's close at 2,049.58 was the first day in positive territory for the new year 2016 (+0.28%) when compared to the final closing price for 2015. A recovery in commodity prices generally and in energy specifically has contributed to the better tone for equity prices in the U.S. and globally over the last 5 weeks. Added stimulus from central banks around the world, including the U.S. Federal Reserve, has also provided a boost for stocks.

Is the "great correction" of early 2016 now over and past? The S&P 500 and the Dow Jones Industrial Average are now "plus" on the year! If "Don't Fight the Fed!" is your rallying cry, then YES, the correction is over and you should be comfortable with an "overweight" position in U.S. stocks. However, if you are old and ugly like me, then you are probably sensing that something is not quite right and that maybe share prices are about to retreat again!

In the interest of full disclosure, I am now 50% short the S&P 500 in my managed accounts. My entire short position was established on Friday, March 18 and is in one single security, the SDS "double short" ETF. For those unfamiliar with this security, when the S&P 500 falls 1%, the SDS actually rises 2%, and if the S&P 500 advances 1%, then the SDS declines 2%.

If the quality of earnings matters anymore, here are some interesting charts and tidbits about GAAP vs Non-GAAP earnings per share for companies in the S&P 500 through 2015:

According to Factset, U.S. non-GAAP "pro forma" corporate earnings for S&P 500 companies are expected to decline -8.0%  for Q1 2016. If this estimate turns into reality, then it will mark the first time the index has seen four consecutive quarters of year-over-year declines in earnings since Q4 2008 through Q3 2009. It will also mark the largest year-over-year decline in earnings since Q3 2009 (-15.7%). 

According to the chart above, at year-end 2015 the S&P 500 Index was trading at 21.2 times GAAP earnings for the trailing twelve months (TTM). If GAAP earnings are down 8% in 2016, which is a likely scenario in my view, then the S&P 500 is really trading now at 23.0 times forward full-year 2016 expected earnings (NOT the widely held view of a much more favorable 15 x forward earnings). If the S&P 500 Index should be trading at 15x forward earnings, does that mean this closely watched index is 53% overvalued? Interesting questions, for sure!

And the outlook for investors may actually be even worse immediately ahead because U.S. regulators are finally looking at this GAAP vs Non-GAAP reporting issue, and they may even take some "unfriendly" action here. Wouldn't that be something!

From a Wall Street Journal report on Wednesday, March 16, 2016 and reprinted on www.marketwatch.com:

U.S. securities regulators are looking at whether it is time to restrict companies’ use of financial metrics that deviate from official accounting standards, Securities and Exchange Commission Chairwoman Mary Jo White said Wednesday. New rules may be needed to “rein in” firms’ use of bookkeeping that doesn’t comply with the generally accepted accounting standards known as GAAP, White told an industry conference in Washington. “Your investor relations folks, your CFO, they love the non-GAAP measures because they tell a better story,” White told the conference sponsored by the U.S. Chamber of Commerce. “We have urged for some time that companies take a very hard look at what you are doing with your non-GAAP measures. “We have a lot of concern in that space,” she said. The use of non-GAAP measures is legal under U.S. securities rules, but companies can’t give those figures greater prominence than official accounting results. 

Bottom Line: U.S. stocks look vulnerable to another major correction on the very near term horizon!

NY Composite Index Daily Chart with 200-Day Moving Average Line