The Profitless Recovery
If the recession's almost over, why are CEOs so anxious and investors so confused? One word: earnings.
FORTUNE
Monday, March 18, 2002
By Justin Fox
fortune.com
The recession of 2001 was supposed to be nasty. You remember, we said so on the cover of FORTUNE in October, and so did a lot of other halfway-reputable people. But guess what: It may already be over. That's what the economic data are saying. It's also the opinion of virtually every economic forecaster out there, including Alan Greenspan. If the economists are right, the recession will not have been nasty at all. Just short. With only one quarter of negative growth (-1.3% in the third quarter), you could even argue it wasn't a recession, which is generally (although not officially) understood to be two straight quarters of GDP contraction.
But try telling that to the folks running America's corporations, who are as gloomy as the forecasters are cheery. Though it's up from the record lows of autumn, FORTUNE's Business Confidence Index (compiled from a monthly poll of financial executives) is still mired deep in recessionary territory. "We are not seeing any improvement,'' says John Dillon, CEO of International Paper and chairman of the Business Roundtable. Clearly the melancholy in executive suites is shared by investors. Since the post-September rebound petered out in January, the stock market can't seem to string two good days together.
What accounts for these parallel universes? One entirely plausible explanation is that the economic forecasters are wrong, and the recovery of late 2001 and early 2002 will turn out to have been a false start, to be followed by an even sharper downturn. That has happened before: Most post-World War II recessions have featured a quarter of growth sandwiched between periods of contraction. Heaven knows there's no shortage of potential dangers that could bring on such a double dip--from a Japan on the verge of depression to an overvalued U.S. dollar, which presumably has to collapse one of these days, to lots and lots of scary terrorists whom nobody has been able to track down yet. Add to that the standard disclaimer: Bad stuff can happen. Good stuff can happen. Nobody, and certainly not the economists of Wall Street or even the Federal Reserve, can reliably predict what is to come.
But what's remarkable about the current state of affairs is that the sanguine economists as well as the downbeat CEOs and investors could all be right. We may well be in the early stages of a recovery, but one that doesn't do much for profits or stock prices.
The disconnect between economic growth on the one hand and business and investing success on the other was striking enough last year. The economy actually grew in 2001, albeit at a pokey 1.2% pace. Corporate profits, meanwhile, plummeted 21% from mid-2000 to the end of September (complete fourth-quarter profit data aren't out yet). The S&P 500, which began sliding in mid-2000, sank another 13% in 2001. Corporate America, and those who invest in it, took a beating.
The economy as a whole escaped such punishment because--well, because of lots of things. Two of the more compelling explanations are these: First, the remaking of the mortgage market by Fannie Mae and Freddie Mac after the savings and loan collapse of the 1980s seems to have banished credit crunches from the housing picture. Home loans at ever lower interest rates have been readily available during the slowdown--which has both stimulated the economically significant housing market and freed up huge amounts of cash for consumer spending through mortgage refinancings. Second, in what could be a long-term development of epochal significance, productivity growth, which usually sags during a recession, continued at a strong pace through 2001 (see The Productivity Miracle Is For Real).
Why, then, were times so rough for corporations? The defaults of countless telecom upstarts and a certain energy trading giant sent the risk premiums charged to all but the safest and soundest corporate borrowers to near-record levels. Which means that, unlike people buying or refinancing houses, most corporations haven't been able to enjoy the full benefit of the lowest interest rates in a generation. And while rising productivity should be good news for profits, it's hard to make much money when the prices you can charge are dropping even faster. The producer price index slid 2.6% in 2001, its sharpest annual decline in 50 years--the result, according to International Paper's Dillon, of overcapacity brought on by global competition, the strong dollar, and, believe it or not, increased productivity.
Then there's the simple but harsh truth that the profit expectations built up during the remarkable 1990s boom (corporate earnings almost doubled between 1992 and 1997) were ridiculously high. The mid-1990s uptick in productivity growth appears initially to have flowed directly to the corporate bottom line--possibly because workers hadn't figured out that they'd become more productive and ought to be getting higher wages. "That's not a sustainable long-term phenomenon," says Lehman Brothers economist Ethan Harris. "You can't have profits rising relative to income." And sure enough, since 1997 employee compensation has outpaced profits. Over time, profits simply can't grow faster than the economy.
So what now? The great news is that productivity is still growing nearly a percentage point faster than it did from 1970 to 1995. But because the working-age population isn't growing as robustly as it was, real GDP growth will probably remain in the 3% range, where it's been for decades, says Standard & Poor's chief economist, David Wyss. If at least a wisp of inflation remains in the air, Wyss figures that it will translate into average annual profit growth of 6%. Which ain't bad, except that CEOs and certainly investors have come to expect better.
How much better? At the end of February investors were paying $29 for every $1 of earnings generated last year by the companies of the S&P 500. If you go by the thumbnail valuation technique known as the Fed model (divide the next year's projected earnings by the yield on a ten-year Treasury note to get the "right" price), that implies that they're expecting earnings to grow 39% this year. Now there surely is room for an earnings bounceback after such a dismal 2001, and the superstars of the S&P 500 probably can be expected to outperform America's corporations as a whole. But 39% is a lot more than 6%.
What this means is that, after the pain of a punctured speculative bubble, the next blow may be the realization that profits just aren't going to grow as fast as they did in the 1990s. There's no telling how investors will react, but at 6% earnings growth and current low interest rates, the P/E of the S&P 500 should be about 22. As for whether the economy can survive profit-starved CEOs and crestfallen investors--well, it survived 2001, didn't it? |
