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Strategies & Market Trends : MDA - Market Direction Analysis -- Ignore unavailable to you. Want to Upgrade?

To: phatbstrd who wrote (24090)	8/28/1999 9:38:00 PM
From: Benkea	Read Replies (1) \| Respond to of 99985

Analysis by Mark M. Zandi 8/27/99 10:54 AM ET Wall Street has heaved a collective sigh of relief in recent weeks as second quarter corporate earnings generally met or exceeded analyst's expectations. Indeed, according to First Call, operating earnings at S&P 500 companies rose by almost 15% year-over-year in the quarter. Analysts are expecting a further acceleration in profits in the current and fourth quarters, with profit growth of over 20%. The seemingly strong profit numbers served to support stock prices during a period of generally higher interest rates and monetary tightening. Most of the major market indices are near their record highs. Investors are rejoicing too quickly, however. Corporate profitability is not as strong as these numbers suggest, and even more importantly, they are not a harbinger of better things to come. The Bureau of Economic Analysis provides a much broader and more accurate measure of profits, and the BEA's numbers are saying something very different. Total economy-wide corporate profits actually fell in the second quarter from the first and they are up less than 5% from a year ago. Moreover, profits have remained largely unchanged for the better part of the past two years after more than doubling during the mid-1990's (see Chart). While the S&P profit numbers should not be ignored by investors, the BEA profit numbers are a more accurate representation of what is going on in corporate America and provide more insight into what is happening in the economy at large. The BEA number includes all companies, those that are publicly traded and those that are privately held. S&P companies are generally larger with more extensive overseas operations. Earnings of these companies got disproportionately hammered in the global downturn last year and they are benefiting disproportionately from the recent global rebound. The S&P profit numbers are also more significantly affected by the increasing use of stock options to compensate employees, restructuring charges and the treatment of goodwill during a merger or acquisition. While these things may be important to understanding why profits change in any given quarter or year, they provide little insight into the longer-term profit picture. The BEA profit numbers provide little solace for the longer-term profit outlook. Corporate profit margins are falling. Margins for nonfinancial corporations have fallen by nearly a percentage point from their mid-1997 peak (see Chart). The only reason total profits are thus growing is that sales growth has been so strong. Real sales of nonfinancial corporations are currently rising at a whopping 5.5% year-over-year pace. This will not continue. The Federal Reserve Board has made it clear that it will continue to tighten monetary policy until the economy and thus corporate sales growth slows. Widening profit margins will not bail out businesses either. If anything, margins are set to narrow even more substantially. Corporate interest expenses are now rising quickly given the hike in interest rates and extraordinarily strong corporate borrowing. Corporate liabilities are currently rising at a double digit pace. Rising energy and other material costs, after last year's decline, will also crimp margins. Labor compensation is also accelerating given the exceedingly tight labor market. According to the Bureau of Labor Statistics, labor compensation per hour grew at a 4.3% year-over-year pace in the second quarter. This is up from a nadir of less than 2% growth back in early 1995, and it is the strongest compensation growth since the early 1990's. The more dour BEA profit numbers have important macroeconomic implications and implications for the conduct of monetary policy. If corporate profits are essentially flat, or at best expanding only slowly, then despite strong productivity gains, businesses will be under growing pressure to raise their prices more aggressively. Productivity growth has been sufficient to offset the impact of more strongly rising compensation costs, at least up till now, but has not been sufficient to offset all the other things that are now beginning to erode margins. Moreover, it may be too much to expect that already robust productivity growth--nonfarm nonfinancial productivity is currently rising at nearly a 3% year-over-year pace--will continue to accelerate to offset what will almost assuredly be accelerating compensation and other costs. Investors will not countenance disappointing profits, particularly given the lofty valuations on many stocks. Examples abound of companies that failed to live up to expectations only to see their stock price get slashed literally overnight. Fearful of seeing their personal net worth slashed as well--now that most senior managers have a large stake in their company's stock price via their stock options--businesses will try to raise prices more aggressively. While S&P profits will continue to shine in the current and fourth quarter of this year, at least when compared to last year's depressed numbers, this will be misleading. The BEA profits will continue to tell a different and more accurate profit story. Moreover, both S&P and BEA profit gains will moderate next year. Businesses will be under increasing pressure to raise prices more aggressively and the Federal Reserve will be under increasing pressure to make sure that businesses are not successful. The biggest loser in this showdown will be those investors who fail to realize that there is one.