-- Happy Days May Not Be Here Again in 2003 --
By Pierre Belec
NEW YORK (Reuters) - Don't hold your breath waiting for the
stock market to hand you a pot of gold next year. Deflation --
an earnings-eating monster that robs companies of the chance to
raise prices -- may hold a gun to corporate America's head.
It will limit the market's upside potential because stock
prices, according to the time-tested rule, represent a right to
future corporate earnings, which will be sub-par.
Indeed, all is not well on the corporate front. Times are
tough for the pin-stripped suits.
In today's intensely competitive environment, chief
executives have lost their pricing power. The pricing issue has
meant earnings problems for a slew of companies. And, if
profits can't grow, how can the stock market recover?
Some companies poked their heads above water in the last
quarter. Profits in the third quarter grew for the first time
in two years, inching up by 8 percent from last year's quarter
-- when earnings collapsed following the Sept. 11 attacks on
the United States.
The reality is the plunge in some sector's earnings had
been so severe that a rebound was inevitable. More easy
earnings comparisons are expected in the fourth quarter,
because less than half of the companies in the Standard &
Poor's 500 index posted any profits in the fourth quarter of
2001.
Also helping to paint a rosier picture is that fewer
companies issued disappointing results. But a closer
observation shows companies were able to pull it off because
they had lowered the Street's earnings expectations. It's the
dumb-down effect.
Much of the earnings improvement stemmed from massive
restructurings, i.e. jobs cuts, and house-cleaning, rather than
from a tremendous boost in the companies' core businesses.
Forecasts call for earnings to leap by 15 percent next
year. But the smart money says don't bet the ranch on any
moon-shot earnings improvement.
UBS Warburg says earnings of the S&P companies will inch up
by only 8 percent next year, If the economy doesn't fall out of
bed.
Going forward, it will be harder for businesses to slim
down further without starving themselves to death.
Companies have found that work force cuts have always been
the quickest way to rebuild their balance sheets. The harsh
truth is businesses can only fire the same workers once. They
will need to be more creative in the second go-round.
An example of the brutal competition: In the second
quarter, revenues of the 400 industrial companies in the S&P
were down 3.3 percent from a year earlier. It was the first
negative comparison since the numbers were first tracked in
1958.
Revenues for 2002 are expected to be off 2 percent, with
deflationary pressures cutting prices by 0.6 percent. The
unexpectedly large drop of 0.4 percent in producer prices in
November, the steepest since May, underscored the risk of
deflation.
A declining price environment or, at best, a period when
prices barely move from year to year, is not good news for the
economy because it essentially translates into the same rate of
growth for the nation's gross domestic product.
The Federal Reserve, which has always focused on fighting
inflation, is now faced with a new script. Lately, it has
gotten religion on deflation, which is the reverse of
inflation.
"The minutes of the November Fed meeting were littered with
the 'D' word and its possible ramifications," says Kent
Engelke, capital markets strategist for Anderson & Strudwick
Inc.
POST-BUBBLE HANGOVER
"There is historical precedent that the economy exhibits a
lack of pricing flexibility following those
once-in-a-generational changes in the economy," Engelke said,
referring to the boom of the late 1990s that was followed by
the bursting of the speculative bubble in 2000.
In the go-go years, companies over-invested and over-hired.
Now the business leaders are paying for their excesses.
While inflation may stimulate the economy and create jobs,
marked deflation affects the economy and the jobs market
negatively.
"There is little question as to what the Fed is really up
to," says Stephen Roach, chief economist for Morgan Stanley.
"The Fed threw down the gauntlet with its larger-than-expected
50-basis-point monetary easing on Nov. 6. The ink was barely
dry on the policy statement of that action when Fed Chairman
Alan Greenspan went public on the deflation debate in front of
the U.S. Congress."
The central bank chopped interest rates last month to the
lowest levels in 41 years, putting the key rate at 1.25
percent, and warned in typical Fed speak: "....a faltering
economic performance would increase the odds of a cumulatively
weakening economy and possibly even attendant deflation."
Central bankers don't appear to be tremendously worried the
economy may be entering a massive deflation spiral, but their
concern is over the changing nature of the economy.
Just Thursday Greenspan mentioned the "D" word again,
although he couched it in optimistic terms. In a speech to the
Economic Club of New York he said recent evidence showed the
economy was working past a soft patch and there was no reason
to fear the country was at risk of price deflation.
"The United States is nowhere close to sliding into a
pernicious deflation," Greenspan said. If a widespread decline
in prices did develop, the Fed chief said, policy-makers had
ample tools to fight it.
INFLATION IS GOOD.... FOR BUSINESSES
Still, there is a clear and present danger the current
no-pricing climate in the post-bubble era, which is crimping
corporate earnings, will continue for as long as the eye can
see, Engelke says. Without inflation, businesses lack pricing
power.
"A problem exists in the fact the U.S. economy is based on
a rising price environment," he says. "People buy a product at
today's prices and pay for it with tomorrow's dollars."
The economy is still not out of the woods yet, and at this
stage of the game business spending will decide the direction
of the economy. The problem is businesses have become much more
dependent on the stock market to finance their growth.
With the Dow Jones industrial average down nearly 30
percent from its peak in January 2000, the S&P down 40 percent
and Nasdaq index off an eye-popping 70 percent, chief
executives have developed a serious case of
"caught-in-the-headlights" paralysis and are afraid to move
forward.
During the booms of the 1990s, stocks soared to dizzying
heights. With record returns on stocks and fat earnings, this
wealth was the biggest driving force behind the high rate of
capital spending by businesses. A lot of the money went into
technology spending, which increased at an unsustainable
double-digit rate each year.
With the market headed to its third straight year of
losses, businesses will likely continue to stick their heads in
the sand and take fewer risk.
So the prospect for 2003 doesn't appear to be good.
Investors who have been anticipating a return of the good
times, may be in for a rude awakening if their rosy outlook
does not materialize. We're talking stock portfolio survival
after three straight years of awesome losses.
For the week, the Dow Jones industrial average <.DJI> rose
0.9 percent, the Nasdaq Composite Index <.IXIC> gained 0.09
percent and the Standard & Poor's 500 Index <.SPX> climbed 0.7
percent. (Pierre Belec is a freelance writer. Any opinions in
the Stocks-Week column are solely those of Mr. Belec. Editing
by Walter Bagley)
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21-Dec-2002 21:22:24 GMT
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