Outlook far from promising
By Philip Coggan
Published: April 5 2002 16:55 | Last Updated: April 5 2002 16:59
The level of share prices is essentially a function of two things: the level of corporate profits and the rating investors are willing to award those profits.
Market valuation is still a subject for intense debate, with some commentators such as Andrew Smithers of investment advisers Smithers & Co, arguing that US equities remain substantially overvalued.
But it is hard to find a bull who believes shares are significantly undervalued; they tend to argue that valuations are fair and that share prices will be lifted by a rebound in corporate profits.
The outlook for profits is thus central to the bullish case.
In both the US and the UK, profits peaked as a proportion of gross domestic product (GDP) in 1997. The subsequent decline in profit share was in sharp contrast to the rapid growth in earnings per share announced (particularly in the US) by the quoted sector in 1998 and 1999.
This discrepancy can be explained in a number of ways.
One might be that quoted companies were performing better than the unquoted sector.
This may well have been the case, but it is hard to imagine that this factor accounted for more than a small part of the gap, given the weight of the quoted sector within the economy. It takes an awful lot of Mom-and-Pop grocery stores to equal one Microsoft.
A second explanation lies in the extra gearing taken on by the corporate sector during the late 1990s. Share buy-backs can lift earnings per share without improving the underlying profitability of the company.
A third explanation, favoured by James Montier of Dresdner Kleinwort Wasserstein, is that quoted company earnings have been manipulated. He points to academic research analysing 1,915 companies that had track records of 41 quarters.
Statistically, no more than 36 should have reported 17 consecutive quarters of increases in earnings per share; in fact, 171 did so.
The after-effects of this manipulation could be quite significant as the global economy and the corporate sector recover.
Because US corporate profits dropped to the bottom end of the cyclical range last year, it is natural to expect them to bounce sharply (and such a trend was observed in the GDP data for the fourth quarter of 2001).
But the danger is that this rebound may simply allow the gap to close between the "real" profit numbers (as represented by the national accounts figures) and the manipulated numbers (as represented by quoted earnings per share). The latter may not grow as quickly as the bulls hope.
Another significant issue is whether there may be structural factors pushing down the profit share. Figures indicate that the "golden era" for corporate profitability was in the 1950s and 1960s.
At that stage, the world economy was relatively closed: capital movements were restricted by exchange controls and domestic manufacturers enjoyed protection from foreign competition.
Back then, for example, the big three US car manufacturers did not have to worry about competition from Japan.
But the modern era of globalisation and the "information revolution", which has made customers more aware of pricing anomalies, may have transferred power from producers to consumers. Peter Oppenheimer, global strategist at the HSBC banking group, points out that many companies are finding that their prices are set globally but their labour costs are still determined locally. In the US and UK, labour markets still remain pretty tight in spite of the recent economic slowdown.
A related issue is the fall in the real and nominal cost of capital during the 1990s as bond yields declined.
In the long run, one would expect the return on capital to equal the cost of capital. But what seems to have happened is that the fall in yields prompted a degree of "money illusion" in the corporate sector.
Managers forgot that nominal and real returns were also bound to decline and thus sanctioned more investment projects than were needed.
Of course, in the long run, this excess capital was bound to drive returns down further through increased competition.
In the short term, however, this extra investment disguised the fundamental problem.
To use nominal figures, say that an economy has $1,000bn of capital and a return of 10 per cent, equivalent to profits of $100bn. Were returns to fall to 7 per cent, that would imply a $30bn fall in profits. However, the corporate sector invests a further $1,000bn of capital. Thus, even at a 7 per cent return, profits still rise to $140bn.
Furthermore, if there is a lag between the fall in the cost of capital and the fall in returns (as there seems to have been in the 1990s), then profits will be given a further temporary lift.
Eventually, however, this process will come unstuck. At some point, business will stop investing and thus there will be no extra capital to raise the headline level of profits.
The forces driving down the average return on capital will then come into play, causing a fall in the overall level of profits.
This probably explains why, in spite of the very mild US economic slowdown of 2001, profits fell so sharply. The signs from the corporate bond market are that the cost of capital is now rising (the signals from the equity market are more ambiguous). Eventually, of course, this will drive up returns.
But companies may find life difficult in the interim, squeezed as they will be between a higher cost of capital and lower returns.
None of the above rules out a rebound in profits this year as volumes expand while costs remain subdued. But this column takes the long view - and over the next five years or so, the prospects for profits do not look encouraging.