disparity between profits at S&P 500 companies and optimistic GDP forecasts
Chief executives vs the statisticians
John Lipsky and James Glassman explain the disparity between profits at S&P 500 companies and optimistic GDP forecasts
Published: April 7 2002 18:39 | Last Updated: April 7 2002 18:55
Who is right about the US economy? Is it the chief executives and financial officers who are facing a round of downbeat first-quarter earnings reports? Or is it the Department of Commerce statisticians, whose calculations of gross domestic product portray an economy that already began producing an impressive profits rebound late last year?
Consider the facts: according to the stunning GDP figures released last week, after-tax profits from current production of all US corporations surged in the fourth quarter, leaving profits 5.7 per cent higher than a year earlier. But this stands in sharp contrast to the 24.5 per cent year-on-year fourth-quarter drop registered in 2001 in the after-tax operating earnings of the S&P 500 corporations.
Who is right? In one sense, both are. Profits have dropped sharply since mid-2000 at the big, high-profile companies that are represented in the S&P 500 index. However, the composition of the S&P 500 over the past few years has become more heavily weighted towards the telecommunications, media, technology, energy and financial sectors. These were precisely the sectors that soared in 1998-1999 but slipped during 2000-2001.
The profit performance of the S&P 500 over the past few years therefore has not reflected accurately the entire US economy. In fact, operating earnings of S&P 500 companies represent only two-thirds of US corporate profits. In contrast, the government's quarterly profit estimates reflect the results from more than 8,000 US corporations.
The gap between reported (S&P 500) and economic (GDP) profits reflects methodological issues as well as the specific sectoral slant of the S&P 500.
Investors' corporate profit perceptions typically focus on corporate reports prepared using generally accepted accounting principles (GAAP). These exclude the impact of cumulative accounting changes, discontinued operations, and one-off charges. However, GAAP- based profits fail to account for other distortions.
The most important of these differences relates to the treatment of depreciation charges. Such charges are deducted from profits under both GDP and S&P definitions. According to the government's statisticians, however, corporations following GAAP guidelines reported depreciation charges on investments that exceeded "true" economic depreciation. In other words, corporations at present are allowed to write down investments more quickly than their economic usefulness expires.
This gap became a significant factor amid the rapid build-up of business investment spending during 1995-2000 and probably accounted for up to a third of last year's S&P/GDP "profit gap".
Other important differences exist between the two accounts but, surprisingly, they would normally tend to reduce, not boost, the reported profit gap.
Most notably, the GDP accounts deduct the cost of stock options from earnings at the time that they are exercised, while S&P operating profits do not deduct employee stock options from earnings at all, in line with GAAP guidelines. Last year, however, it is likely that the cost of options exercised waned, so the effect would have boosted 2001 GDP profit growth. Other methodological differences do not create meaningful divergence in the outcomes.
Last quarter's profits surge may also have been obscured in part by Wall Street's focus on year-on-year profits comparisons. This practice reflects the practical unreliability of seasonally adjusting any single company's quarterly earnings. The GDP-based profit figures are seasonally adjusted, which is a much more reliable exercise when applied to aggregate figures.
While this adjustment did boost GDP profits in last year's final quarter, seasonal factors for last year's fourth quarter nonetheless have to be viewed with caution.
Cutting through the technicalities, there is little mystery why broadly measured profit growth is rising. Companies in all sectors have been squeezing out new productivity gains in spite of an economic stall that left national output roughly flat last year.
Furthermore, businesses have been curbing costs, including slowing wage gains. With sales volumes growing since late last year and unit labour cost falling, corporations' after-tax cashflow has rebounded to a record level and is relatively high even as a percentage of national output.
If this more upbeat profits analysis is correct, it will go a long way to explaining another mystery: why the US stock market has continued to support a historically impressive ratio of stock prices to reported operating earnings. In fact, the GDP accounts indicate that the after-tax profits share of national output has already been restored to the level reached in the mid-1990s, largely reversing the slide that began in mid-2000.
The chances are that chief executives are going to have a more upbeat story to tell in the next few quarters.
The writers are senior economists at JP Morgan in New York |
