SERIOUS MONEY: The second longest earnings expansion enjoyed by corporate America over the past half-century came to a halt during the third quarter as big business reported the first year-on-year decline in profits for the first time in more than five years and the lowest outcome since the first three months of 2006.
Analysts continue to revise their estimates downwards for the year's final three months and for 2007 as a whole the world's largest corporate sector is set to post an indifferent performance.
The blue-sky merchants believe that the earnings recession will last no longer than two quarters and double-digit growth is expected for 2008. Unfortunately, such optimism is based on fantasy rather than fundamentals and a more realistic assessment suggests that a decline next year is far more probable. The boom in corporate profits is at an end and a downturn that could see earnings drop by as much as 20 per cent has just begun.
Financial market indicators hinted at the stress that corporate America would inevitably endure several months ago but the optimists not only on Wall Street but also at the Federal Reserve in Washington ignored the signal.
The yield curve, which measures the spread between short-term and long-term interest rates, is a leading indicator of corporate profitability beyond compare and is reasonably accurate at the time of reading in explaining the variation in profits over the subsequent two years.
This indicator predicted correctly in early 2006 that the earnings upturn would end towards the end of this year but the message was ignored as fanciful theories abounded and the most dangerous words in investing - this time it's different - became part and parcel of the Wall Street lexicon once again.
The current profit cycle saw the return on equity and profit margins soar to levels that are well beyond historical experience.
Despite the disappointing performance during the autumn months, the return on equity remains four percentage points above long-term averages while margins exceed historical experience by three percentage points.
Furthermore, current earnings relative to their 10-year average are at their highest level in almost 60 years and today's reading has been exceeded just three times over the past century. Needless to say corporate profitability has suffered in the years following such high readings - with or without an economic slowdown, as the mean reversion of competition and true capitalism takes hold.
Financial market indicators and the available historical evidence both predict that corporate America's revival following the accounting fiction and subsequent demise of Enron and WorldCom is now at an end and this conclusion is corroborated by studied top-down analysis.
The debt-fuelled economy is flirting with recession and even if a downturn is avoided, growth is almost sure to be sub-par for a protracted period. Needless to say, the corporate sector is inextricably linked to the economic cycle and when nominal GDP is sustained at 4 per cent or below year-on-year as seems certain through 2008, revenue growth slows and profit margins decline, which inevitably leads to an earnings downturn.
Corporate America's good fortunes in recent years have been built upon a concerted effort to reduce variable costs - both operating and financial, and incremental revenue increases dropped straight to the bottom line. Unfortunately, operating and financial leverage work both ways and the factors that drove profitability higher have now reversed direction.
Unit growth has slowed in line with the economy's travails and the drop in capacity utilisation below 80 per cent has limited pricing power. Meanwhile, several factors have converged to aggravate cost budgets.
Unit labour costs increased sharply year-on-year during the third quarter while input prices, which typically hit cost structures with as much as a 12-month lag, continue to hurt.
Meanwhile, the ongoing turmoil in credit markets has raised funding costs and will cause some to question the merit of continuing share repurchase programmes, which have added more than two percentage points to growth in earnings per share in recent years.
An earnings downturn has begun but the blue-sky optimists will be quick to argue that stocks are cheap. They are wrong. Valuations are not cheap with prices trading on 14 times forward or fantasy earnings as compared with 12 times over the past 25 years. Furthermore, stocks are currently priced at 20 times trend earnings, which is closer to 25 if those so-called one-time charges are included. The evidence suggests that caution is still warranted as market turbulence could return at any time.
