Profit mirages

IF THERE is a $64,000 (or rather $64 billion) question facing stockmarkets, it is what will happen to corporate profits. A key component of the bullish case is that valuations (in terms of price-earnings ratios) are reasonable; stock market bubbles tend to occur when such ratios reach well above 20, whereas today they are in the mid-teens.

The bearish side would argue that we have witnessed a profits bubble rather than a valuation bubble. American profits are close to a 40-year high as a proportion of national output. If share prices are valued using a 10-year average of profits, then they look very expensive indeed by historical standards.

And it is not just American companies that have been doing well. According to HSBC, the latest set of data on British companies show that, in 2006, profitability (as measured by return on capital employed) reached its highest level since records began in 1965.
The conventional explanation for the surge in profits is related to globalisation. The integration of the Chinese and Indian economies into the global economy has added substantially to the workforce, reducing wage pressures. At the same time, developed-world economies have become more dependent on services than manufacturing; in the former, profitability tends to be both higher and less cyclical.
But there may also have been other factors at work. Goldman Sachs, in a recent note titled "Profits under Pressure", calculates that two sectors, distribution and financials, have done particularly well. Both have benefited from the extensive use of technology to improve productivity while avoiding the splurge of capital investment that hit the telecoms and internet sectors in the late 1990s.

But this does mean that the profits picture is a little unbalanced. Around a third of the profits growth in the last ten years has come from the financial sector, according to Longview Economics. Over the last five years, a good deal of impetus has come from the energy sector, with Lombard Street Research calculating it was responsible for 23% of profits growth over the 2001-06 period. Otherwise, business is not enjoying that much of a boom. Goldman remarks that "margins in many non-financial industries remain at historically unremarkable levels".
Apart from the sector effects, there has also been a boost to earnings per share (EPS) from share buy-backs. Lombard Street Research says this factor was responsible for 7.2% of EPS growth in 2005 and 10.7% in 2006; it cites Thomson Financial as expecting that a fifth of all EPS growth this year will come from buy-backs. This has reflected the relative cheapness of debt compared with equities and cannot continue forever, not least because it would imply the quoted stockmarket disappearing altogether.
Similar arguments could be made for the energy and financial sectors. Oil has marched from $20 a barrel to $80 a barrel in recent years; that pace cannot continue (but if it did, profits in the rest of the economy would surely suffer). Similarly, while the financial sector has benefited from technology, it has also been boosted by rising asset prices and credit growth; the latter, in particular, looks under threat.
And then there is the slowing economy. America may escape recession, but it is definitely suffering a slow patch. The effect on profits has so far been disguised by the weakness of the dollar. But to the extent that allows American companies to gain market share (or has a translation effect on the profits of overseas subsidiaries), companies from other nations must be suffering.
As Goldman points out, analysts’ forecasts of 12% profits growth next year do not seem credible. Indeed, they may not grow at all. As the graph shows, the gap between the profits reported by companies and those calculated in the national accounts figures is wide, just like it was in the late 1990s. And look what happened after that.