Three weeks ago, when looking at the incoming Q4 results, we were stunned by an unprecedented divergence: that of GAAP and non-GAAP earnings. We showed this difference as follows:

... and noted that while on a non-GAAP basis, the S&P's trailing P/E is a relatively rich 16.5x (over 17x as of today), it was the GAAP P/E that was troubling, because at just 91.5 in actual S&P EPS, this implies that the GAAP P/E of the overall market is now a near-record 22x.

We showed the delta between GAAP and non-GAAP as follows:

At a dollar difference between the two "earnings" series of $26.5, this was the widest such spread since the financial crisis.

Unsure what to make of a spread that was so gaping, and a market that is so broken not to notice, we concluded as follows:

What can possibly short-circuit this positive feedback loop which leads to ever lower earnings, and increasingly lower prices? Two years ago we would have said another major central bank intervention or trillions in new Chinese loans. However, with both of these loopholes largely played out - China's debt/GDP of 350% means that the entire nation is on the brink of a Minsky Moment collapse at any, well, moment, while recent central bank intervention have only led to even greater market volatility - this time around we don't know what the true answer is. In fact, it just may be that this time around the market will actually have to crash, like it did in 2008 when the GAAP to non-GAAP spread was just as vast, for the great Wall Street "phony earnings" game to start from scratch.

What we forgot was the desperate actions by the ECB which may have kicked the can by a few more months, in the process sending the S&P 500 to an even more overvalued state.

But while for now the market is stubbornly refusing to crash, someone else noticed our analysis: Goldman Sachs' chief strategist David Kostin who presents the following oddly familiar (granted we use column charts; Goldman uses line charts) of GAAP (or rather "operating") vs non-GAAP earnings and the spread between them...

... and says "only three times during the past 25 years has the difference between operating and adjusted EPS exceeded 10%. In 2015, the gap totaled a staggering 18% or $18 per share, with impairment charges by Energy firms responsible for half the difference. Last year’s difference was only surpassed by the record 31% gulf in 2009 at the depths of the global financial crisis."

Then there is the question of the drop in earnings, because as we pointed out it is not so much about the 4th consecutive Y/Y drop in EPS, but the gargantuan 12.3% crash in 2015 GAAP EPS which even Factset pointed out over the weekend.

Sure enough, Goldman covers this as well:

S&P 500 operating EPS fell by 11% to $100 in 2015 while adjusted EPS dipped by less than 1%. As a result, the gap between operating and adjusted EPS surged to $18 or 18%. For 2016, we forecast the variance will narrow to 8% as operating EPS rises by 10% to $110 while adjusted EPS increases by less than 1% to $119.

It is unclear where this massive surge in GAAP earnings will come from unless of course oil soars to $100 in the next few months, something even Goldman's commodity team is saying won't happen and instead oil will trade in the $25-$45 range for a long time.

This brings us to the next point: what it this huge spread between real and fabricated earnings the result of? The answer: energy companies.

Where did this massive difference between GAAP and non-GAAP come from? Mostly energy names.



Energy asset write-downs contributed $9 per share or 50% of the $18 difference between S&P 500 operating and adjusted EPS in 2015. Other sectors contributed to the gap including Health Care, Information Technology and Materials. The four sectors comprise 95% of the accounting difference between the two measures of earnings. Looking ahead, we expect 2016 Energy impairment costs will total $5 per S&P 500 share, more than half of the $9 difference between operating and adjusted EPS. Energy firms take ceiling test write-downs based on trailing 12-month average oil price. The futures curve suggests Brent crude will average roughly $37/barrel in 2016, a full 29% below the average cost per barrel in 2015. Even if the spot price of oil rises modestly this year, the trailing average price is unlikely to increase until 2017.

Good luck, especially since as even Goldman notes, it was wrong once already:

"Ceiling cost impairment charges by Energy companies were larger than we expected. Consequently, S&P 500 operating EPS was lower than we had forecast ($100 instead of $106). Looking ahead, we have lowered our 2016 operating EPS forecast to $110 from $117." ... and then, just like Warren Buffett, Goldman adds that "we prefer operating EPS as a gauge of profitability."

Oops, because we expect this $110 to be lowered back to $100 once again in short notice, forcing Goldman to drastically slash its year end S&P target, although all this will happen in baby step terms and we are certainly happy that Goldman finally admits that its earnings-based growth assumption was wrong all along (the firm last many months ago that multiple expansion is no longer possible).

What Goldman does get right is the following:

"Operating and adjusted EPS both indicate high S&P 500 valuation"

Being Goldman, of course, the firm can't admit that even as it cuts operating earnings forecasts it also has to cut its year end S&P target (at least not yet), and so is keeping its 2,100 S&P500 target:

Despite lowering our operating EPS projections, we continue to forecast the S&P 500 index will end 2016 at 2100, roughly 4% above the current level. Looking ahead, the trajectory of the S&P 500 index will track slightly below earnings growth, rising to 2200 (+5%) in 2017 and 2300 (+5%) in 2018.

Where will the growth come from? Not P/E expansion that's for sure:

In December, the Fed raised the target funds rate for the first time in nearly a decade. Investor attention has now turned to the path of future increases and the implications for stock valuation. Our US economists expect 75 bp of rate increases in 2016 starting in June, while the futures market implies 25 bp of hikes. Rising interest rates and tighter financial conditions suggest further valuation expansion is unlikely. The forward P/E declined by an average of 10% during the 12 months following the start of prior tightening cycles. We expect the forward P/E multiple will contract by 7% between the end of 2015 and 2016 based on our top-down operating EPS estimates. Our year-end 2016 index price target of 2100 reflects a forward P/E multiple of 17.1x our 2017 top-down operating EPS forecast of $123 (assuming an 8.9% margin). The current S&P 500 valuation expansion cycle that began in late-2011 has seen the forward P/E rise by nearly 60%, and has persisted more than three times longer than the typical 16-month expansion. Additional Fed interest rate hikes add to the case against continued valuation expansion. Both the aggregate S&P 500 index and the median stock trade at above-average multiples compared with history.

And the punchline: Goldman blames "consensus" for being overly optimistic.

Consensus bottom-up EPS estimates incorporate what we believe are unrealistic margin expansion assumptions. Our year-end 2016 S&P 500 target of 2100 equates to a forward P/E multiple of 15.6x an aggressive bottom-up adjusted EPS forecast of $135 that assumes a 10.1% margin. As discussed previously, every 100 bp shift in margins translates into roughly $10 in EPS. Depending on the P/E multiple assumed, the incremental $12 in EPS from higher forecast margins translates into roughly 200 points on the S&P 500 index.

Don't worry though: while multiple expansion is over, as is earning growth, something else will keep stocks propped up: the only thing that has been buying stocks in the past 4 years while everyone else sold - corporate buybacks, of course.

Although we believe valuation expansion from current levels is unlikely, corporate repurchases should keep any valuation declines contained. We forecast S&P 500 firms will return more than $1 trillion to shareholders in 2016 with buybacks growing by 7% to $608 billion. Repurchase authorizations YTD have established a new record. Corporate buybacks continue to represent the primary source of demand for US equities.

Which explains why Mario Draghi effectively gave European firms a carte blanche to buyback their stocks with the ECB's bond backstop.

So having been well ahead of Goldman as usual, here is what we thing will happen in the next 3-6 months: Kostin will cut his year end price target from 2,100 to 1,800 or lower as the mythical operating income growth fails to materialize, as mutiple expansion goes into reverse, and as the market increasingly punishes companies with record net leverage for engaging in even more buybacks once the current short squeeze euphoria ends.