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Sunday July 29 03:05 PM EDT

A Plunge in Profits Raises Risk for Stock Market and Economy

By ALEX BERENSON The New York Times

For the first time in a decade, corporate America's profits are plunging, creating what some economists see as significant risks for the stock market and economy alike.

In profit reports released over the last two weeks, large publicly traded companies said that their earnings fell an average of 17 percent in the second quarter, compared with a year earlier.

The rapid reversal has stunned Wall Street. Just seven months ago, analysts expected profits to rise 9 percent for the full year. They now forecast that earnings will drop more than 8 percent this year, or $30 billion, according to Thomson Financial/First Call, which surveys analysts' forecasts. The decline would be the first in annual profits since 1991.

The profit squeeze along with Friday's report that the economy grew by an annual rate of only 0.7 percent in the second quarter raises fears that the nation may be moving closer to a danger of recession than it has in the last decade. While some economists are optimistic, thinking that the tax rebate and falling interest rates make stronger growth likely this fall, shrinking corporate profits could worsen the economic downturn already in progress.

"The risk is that the profits recession becomes a recession for consumers and therefore a recession for the entire economy," said Edward Yardeni, chief investment strategist for Deutsche Banc Alex. Brown. "By September, when company managements come back from the beach, if they don't get a sense that things are significantly improving for profits, you're going to see another round of cost cuts, which will this time include payroll cutbacks."

The drop in corporate profits also means that investors hoping for a rebound in stock prices may have to wait, many investment strategists say. They argue that stocks which began falling from their high point more than 16 months ago are unlikely to recover until Wall Street can be confident that earnings have hit bottom and better times are ahead.

But a turnaround in corporate profit now may be two quarters away. Wall Street analysts are reducing their earnings estimates for the second half of the year, said Charles L. Hill, research director for First Call. He expects profits at the large companies that make up the Standard & Poor's 500-stock index to fall more than 10 percent for the year.

And even that estimate may understate the extent of the business slump, because it excludes tens of billions of dollars in what companies define as one-time losses. These special charges have been taken by struggling companies like Lucent Technologies and, last week, JDS Uniphase to cover the costs of layoffs and to account for the plummeting value of their pricey acquisitions.

Although technology companies have recorded the largest losses, the problems during the second quarter spread beyond technology, with brokerage firms and some consumer products companies also struggling. According to First Call, profits of the S.& P. 500 companies, excluding technology producers, fell 7 percent in the quarter ended June 30 after remaining flat in the first quarter of 2001.

"I'm struck by the continued negative picture that's presented on a month-to-month basis," said Jerry Jasinowski, president of the National Association of Manufacturers. "We're building the basis for a recovery, but there's not any clear evidence of an upturn yet."

In the late 90's, a boom in corporate spending, especially for computers and software, lent force to an already strong economy. But with earnings weak, such investment which fell off sharply late last year will recover only slowly, technology executives say. On Friday, the government reported that corporate investment fell at an annual rate of 13.6 percent in the second quarter.

Making large sales of software has become much more difficult, said Bob Beauchamp, president of BMC Software in Houston.

"A lot of what we're dealing with is just earnings pressure, quarterly earnings pressure," Mr. Beauchamp said, explaining his customers' reluctance. "Nobody is going to go in with a big blank check and write you a check for $20 million. During the go-go dot-com days, the budgets were looser."

Consumer spending remains the strongest part of the economy, and so retailers like Home Depot and Wal- Mart are anticipating solid gains in profit. Home Depot, based in Atlanta, expects to add 50,000 employees and open 204 new stores by the end of the year.

"We are not taking our foot off the growth accelerator even though the economy is weak," said its chief financial officer, Carol B. Tome.

A prolonged drop in profit might carry additional damage on Wall Street. Despite its skid, the stock market as a whole remains expensive relative to its declining earnings. The price-to-earnings ratio of stocks in the S.& P. 500 index now stands at about 24, far above the historical norm. A high price-earnings ratio is a sure sign that investors are hoping that falling profits represent only a short-term aberration.

For example, major airlines in the United States are expected to lose a total of about $1.5 billion this year, compared with combined profits of $3.8 billion in 1999, said Samuel Buttrick, airline analyst at UBS Warburg. Mr. Buttrick said his estimates of industry losses had worsened markedly since May, because new data shows that domestic airline revenue dropped about 10 percent in both May and June, the most rapid decline in at least 25 years.

"In the past two months," Mr. Buttrick continued, "profit forecasts for 2001 and 2002 have been cut at the fastest rate in the last decade." A few months ago, he expected the UAL Corporation, the parent of United Airlines, to break even this year. Now, he predicts that UAL will lose almost $20 a share.

But even as Mr. Buttrick and other analysts have cut their estimates, the prices of airline stocks have risen. This disconnection between earnings and profit "suggests a certain level of benign complacency on the part of investors that things will get better and get better quickly," Mr. Buttrick said. "I think the rate of recovery is likely to disappoint investors."

With technology stocks, even though their prices have plunged, earnings estimates for big technology companies have fallen so far that many stocks still look expensive relative to company earnings. A few months ago, analysts expected that Cisco Systems, the leading maker of Internet equipment, would earn nearly $1 a share, or $7 billion, for the next fiscal year, ending in July 2002. Now they forecast Cisco to make 27 cents a share, or less than $2 billion, excluding one-time charges.

On Friday, Cisco's shares closed at $19.06, less than one-fourth their March 2000 high of $80.06. But because profit forecasts have plunged, the company's shares, by some estimates, trade somewhere between 47 times estimated 2002 earnings and 73 times. As a result, Cisco and some other technology stocks could fall further, pessimists among the analysts warn. In March, Cisco said it would lay off up to 5,000 employees, or 11 percent of its work force.

Douglas R. Cliggott, chief equity strategist at J. P. Morgan, who warned last fall that earnings estimates were too high, said investors had still not accepted how weak earnings would be at least through the end of this year. Within days, he said, he expects to cut J. P. Morgan's earnings forecast for the S.& P. 500 for both 2001 and 2002. "It looks to us, unfortunately, like the earnings numbers are still too optimistic," Mr. Cliggott said. "There's a lot of risk."

-- (M@rket.trends), July 30, 2001

Answers

sounds like we should put social security into the stock market and let old people gamble with their little bit of old age survival income.

-- Cherri (jessam6@home.com), July 30, 2001.

"Despite its skid, the stock market as a whole remains expensive relative to its declining earnings. The price-to-earnings ratio of stocks in the S.& P. 500 index now stands at about 24, far above the historical norm. "

If I am not mistaken, the historic norm is about 16.

For the purposes of comparison, if we assume a similar overvaluation in the DJIA (not necessarily a good assumption - but most people don't follow the S&P 500 that closely) that would be the equivalent of a DJIA "fairly valued" at about 7,000.

My guess is that, if the S&P 500 were to return to this kind of historic "fair valuation", it would be so shocking to the small 401K-type investor that it would drive many of them out of the market with heavy losses and overshoot "fair valuation" on the way down. There is obviously a hell of a lot of downside risk there.

That is why the Fed will ease again in August and keep easing until it sees an upturn in profits... or we end up like Japan in the 1990s.

-- Little Nipper (canis@minor.net), July 30, 2001.

Well said Nip. Worse, we could wind up like the Japan of 2001. Lending rates cut to below zero ( considering inflation ) and no corporate takers cause not only can they not handle more debt at any rate but there isn't anything they want to buy except maybe a few harakiri knives. Seppuku has its place, afterall.

-- Carlos (riffraff@cybertime.net), July 31, 2001.

"sounds like we should put social security into the stock market and let old people gamble with their little bit of old age survival income."

- The Social Security Administration (not Congress, not the President) says that in 2016 SS will start to have outlays greater than inflows. So do you propose raising taxes, or cutting benefits, or both???

- Once again you insist on two obfuscations 1) that ALL SS inidividual funds would be privatized; and 2) that the stock market is the only option for the privatized funds (ever hear of treasuries, or bonds, or etc. etc.?)

-- libs are idiots (moreinterpretation@ugly.com), July 31, 2001.