Stocks are falling because corporate profits are falling back to their normal percentage of GDP after swelling far beyond that. Since the market usually prices stocks as a multiple of their expected earnings, falling earnings usually mean falling stock prices. Important as the profit numbers are, the way we got there may be intensifying the market’s sour mood.
In 2007 corporate profits accounted for 14% of GDP, about double the usual level, a 55-year high. At the beginning of 2007, S&P expected earnings for the S&P500 (SPX) would come in at $92 per share for that year. Now, Merrill Lynch economist David Rosenberg expects to see $28 per share for 2009 and (optimistically in my view) a rebound to $55 for 2010, according to the February 14 edition of John Mauldin’s online newsletter. In other words the market price of the SPX was based on forward expectations of $92 in earnings just two years ago, and is now looking at $55 next year if we are lucky. And the market may be conveniently overlooking, if not wishing away, the goose egg we are laying this year. The downward trend from the 2007 peak is not good news either.
But just how real were the peak earnings in the first place? Clearly in financial services, not so much. For example, take the financial companies’ earnings reports for 2006. To make the 2006 earnings picture reflect economic reality, we would have to reduce earnings reported in 2006 that were derived from transactions made and loans extended that year, by the subsequent write-offs related to those transactions.
Non financial earnings may have been more “real” but they were less than sustainable in many cases. A key problem here lies with the off shoring of the US industrial base. It runs like this. Since the Reagan years, American companies have moved jobs overseas to take advantage of cheaper labor. The idea was to make things cheaply over there, sell them at retail over here, and fatten profit margins. The problem is that by shipping so many good jobs over there, American companies reduced the number of Americans who could afford their products. Managements thought they were serving their customers better by cutting prices but they ended up destroying many of their customers instead. Off shoring works if you are the only company doing it (your employees land good jobs elsewhere and continue to afford your product) but not if everybody does it (and the employees are forced to take lower wage jobs, assuming these can be found).
Henry Ford would never have done this. He paid his workers the then unheard of wage of $5 per day and he didn’t do it out of charity. He did it because he wanted to expand the market for automobiles. He wanted consumers who could afford the products they made.
I know that some people think that our companies had to off shore in order to stand up to foreign competitors. My answer to that is two-fold. First, many countries like, for example, China, have figured out how to game the WTO rules so that they can export goods to other countries and keep imports out, while staying within the letter of the agreement. Secondly, German and Japanese companies, for example, seem to make more efforts than our companies do, on balance, to keep jobs at home.
In the early part of this decade, consumers kept up their lifestyle despite stagnant or falling incomes by borrowing against their homes so they could buy more “stuff.” Eventually that strategy failed when home prices crashed. No one could expect any longer to get bailed out of their home equity loans with profits to be earned by selling their home to the next buyer at an ever more inflated price.
Consumers were supporting their spending not with wages but with asset price gains. Funding your purchases by taking money out of your home is very different than funding them out of ongoing wages. You can only take money out of your home, once. Similarly, corporations could only plump up their earnings by off shoring their labor, only once. If you increase profits by finding lower cost ways to manufacture by improving technology or expanding know-how, that is part of the ordinary course of business. In other words: the big increase in corporate profits reported in the last 15 years was an anomaly, similar to what security analysts would call a one time gain.
When security analysts dissect earnings reports we differentiate “operating” earnings which spring from a company’s usual course of business, from “one-time” gains that come from such items as the gain realized from the sale of a major asset such as land, a building, or a corporate division. I would contend that much of the increase in corporate earnings between, say, 1990 and 2006 were in fact, one time gains.
As the market drops, investors are waking up to a cold fact. Corporate earnings will not rebound to 2007 levels any time soon — assuming those earnings existed in the first place.