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To: ild who wrote (245198)	6/12/2003 1:26:00 AM
From: ild	Respond to of 436258

Where Are the Profuits? A. Gary Shilling, 06.23.03, 12:00 AM ET The rally hangs on a rousing increase in corporate income--an increase that doesn't square with either economic or political reality. Wall Street analysts assure you of robust profits to come. For 345 of the S&P 500 index companies, they expect earnings growth exceeding 10% per year for the next three to five years, and for 123 of these companies, more than 15% per year. The rosy view does not exclude tech companies, which have suffered mightily in the past three years. Analysts forecast 10%-plus yearly profits growth for 82 of the 91 tech stocks in the S&P 500 index, and greater than 20% for 18 of them. All told, forecasts for component companies add up to $61 per S&P unit for earnings for 2004, before writeoffs. The $61 represents a rousing double from the $28 that S&P reports for bottom-line, postwrite-off earnings over the past 12 months. This zealous belief in prosperity around the corner is understandable. Analysts still get paid to push stocks and want to curry favor with corporate managements. And they really want the rally to stay alive. Without big profit gains to come, today's high stock prices don't make any sense. Right now the S&P 500 is trading at 31 times trailing earnings (after writeoffs), far above the historical average of 15. For stock prices to get back into line, either profits have to shoot up or stock prices have to tumble catastrophically. Here's what's wrong with the theory that earnings will gallop ahead. The consensus forecast for the economy is modest: a real annual gross domestic product growth of 3%, coupled with 2% inflation in the years ahead. That means nominal GDP is rising at 5%. How can profits race ahead at 10% when the economy is growing at 5%? They can't. Historically, corporate sales increase in step with the economy and profits grow slower than that. From 1959 through 2002 GDP rose an average 7.3% per year and nonfinancial corporations' sales also climbed 7.3%. Pretax profits for those same companies, however, went up only 6.2% annually. S&P 500 companies' reported earnings increased still slower, at 5%. Analysts hope for earnings leverage from rising sales volume and prices, cost-cutting and financial leverage. But slippage and overhead increases take their toll. There are spurts of higher profit gains, such as when the economy comes out of recessions--or in the 1980s and 1990s, when inflation unwound and restructuring reigned. But over the long pull corporate profits can't outrun the economy unless labor's share of national income falls. In a democracy, that's a political impossibility. So the key to the profits outlook is economic expansion. I look for 2.5% annual growth in real, or price-adjusted, GDP in the years ahead. There are three reasons it can't move faster. First, gigantic excess industrial capacity will curtail any meaningful capital spending boom for years. Second, consumers are embarking on a saving spree after a 20-year borrowing-and-spending binge. The switch from spending growing 0.5% faster than aftertax income to growing 1% slower will cut one percentage point off GDP growth. And third, deflation is unfolding. I continue to forecast the good deflation of excess supply, driven by new tech-spawned productivity growth--and thank the Federal Reserve's recent public deflation worries for making my long-held forecast credible. Trouble is, few expect deflation and are prepared for it. Deflation will push up the real cost of gigantic corporate and consumer debts, and reducing them to size will be challenging. With 2.5% real GDP growth per year and 1% to 2% deflation, nominal GDP will advance 1% annually. That doesn't leave much room for profits to soar. Moreover, the writeoffs of the 1990s excesses will probably continue for years. Companies never seem to get all the cancer out in the first several trips to the operating room. Earnings will also suffer as artificial profits from defined-benefit pension funds vanish and companies are forced to shell out real cash to prop up these lagging funds (see my Sept. 2, 2002 column). And of course, with global deflation, corporate pricing power will erode further. On balance, in the years ahead, count on low corporate earnings growth. If you assume that I'm right with my mild deflation forecast, Treasury yields will decline enough to justify current p/es. Then stock prices will go up about 1% annually--only as fast as profits rise over the next decade. If instead you accept the consensus forecast of 2% inflation and the historic 2.5% risk premium for stocks versus Treasurys, a 13 P/E is in the offing, less than one-half the current level. So, even with 4% annual earnings growth, stocks would decline 38% over the next decade. With my forecast of deflation, I'm the optimist on stocks. forbes.com