There’s a historic ravine between reported earnings and cash flows in the US, and it doesn’t bode well.

That’s according to Morgan Stanley’s Mike Wilson who, despite conceding that stocks may be able to sustain a rally until the profit malaise he expects becomes too obvious for investors to ignore, nevertheless retained a medium-term bearish outlook in his latest weekly missive.

The analysis of accrual earnings Wilson cited actually comes from the bank’s Global Valuation, Accounting and Tax team, but Wilson believes it’s extremely important for his highly publicized negative operating leverage thesis.

The dynamic isn’t difficult to grasp, and it’s probably best illustrated by the figure below, which is actually a secondary chart (i.e., not the visual Wilson gave top billing).

The yellow line is the ratio of reported net income to funds from operations or, more simply, cash flow from operations sans working capital oscillations. The idea is to determine the extent to which growth in the non-cash component of earnings is down to working capital or some other balance sheet item. The chart suggests it’s a function of excess working capital.

Why is that a problem? Well, as Morgan Stanley noted, “the surge in working capital is primarily attribut[able] to the accumulation of excess inventory and capitalized costs due to supply chain issues, COVID, shortages, rising wages and potentially misjudged demand.”

That might be ok if companies are able to collect quicker, but Morgan Stanley’s concern is that the readily discernible improvement in receivables collections “has likely approached its limit and may even revert in a slowing economy.”

There are two ways the ratio illustrated on the right above can normalize: Either companies can discount or write-down inventory at the expense of margins and profitability, or management can try to change the denominator by increasing sales, likely through additional price hikes. In Morgan Stanley’s view, that latter option isn’t especially viable given the already “inflationary environment and a watchful Fed.”

So, again, this is just another piece of evidence to support a pessimistic view for margins and profitability going forward. And that’s the key to Wilson’s bearish medium-term outlook for US equities.

Commenting on the analysis from the bank’s GVAT team, Wilson said it “could not be better timed.” “It lines up very nicely with our negative operating leverage thesis, which is driving our well-below-consensus margins and EPS forecasts for the S&P 500,” he wrote, adding that it “also suggests this over-earning dynamic is quite broad across a large majority of sectors in the economy.”