Headline: Things were not as they seemed: Profits of the great bull market weren't as hot as we all thought

Source: Boston Globe, 5 August 2001

URL: http://www.boston.com/dailyglobe2/217/business/Things_were_not_as_they_seemed+.shtml

Rising profits were one of the pillars of the great bull market of the late 1990s. Now it looks as if that pillar was not as sturdy as we thought.

The government last week quietly revised its measure of profits for the years 1998, 1999, 2000. The new calculations show that corporate profits were actually about $135 billion less than originally estimated. If you think this is news only an accountant could love, think again.

In economics, profits are inextricably linked to other things, such as the cost of labor and productivity, both of which now look less dazzling after the revisions. Add up all the new numbers and the conclusion is a depressing one. ''The new economy was not as good as it first appeared,'' said Fred Breimyer, chief economist at State Street Corp.

But it doesn't stop there. If the past was not so great, what does that say about the future? Can the American economy grow quickly without generating inflation? Is the new technology all it was cracked up to be? And more to the point for investors: Can profits snap back the way Wall Street wants them to?

Richard Berner isn't so sure. ''The consensus forecast on earnings for next year is still way too high,'' said Berner, chief US economist at Morgan Stanley. If Berner is right, and we are all still wearing rose-colored glasses, then investors may be in for some future shock when reality fails to meet expectations.

Revising the past is standard stuff for the government. Each year statisticians pore through the latest numbers and update earlier estimates. Frequently the changes amount to major rewrites of history. If government economists lived in Russia several hundred years ago, Ivan The Terrible might have become Ivan the ''Pretty Bad'' and Peter the Great could have been Peter the ''Merely Good.''

Last week's revisions produced a very different view of 2000. Instead of growing 5 percent as originally thought, the US economy grew 4.1 percent. The profit revisions went in the same direction. There were big reductions in 2000 profits and smaller revisions for 1999 and 1998.

But the most interesting numbers may have been a more obscure set of figures that measure profit margins or the share of the economy's output that winds up as profits. Warren Buffett, a pretty fair investor, attaches great importance to the profit margin numbers. Buffett believes that the rise in those margins from the early 1980s to the late 1990s was a key driver of the great bull market of the last 20 years. As Buffett put it in a 1999 Fortune article, ''The value of an asset cannot over time grow faster than its earnings do.''

There's just one problem. Profit margins peaked in 1997 and have been dropping since. For the past few years some of the money that once flowed to profits flowed to the American worker, in the form of higher wages. In 2000, wages climbed 8.2 percent, up from the original estimate of 6.7 percent.

For investors, that shift was not good news. ''Corporate America is not doing as well as it was before,'' said Breimyer. American companies took on those added costs just as the economy was turning down. That mismatch explains why business has shed so many workers this year. Friday the government said that another 42,000 jobs disappeared in July.

The rewriting of history isn't finished. The government this week will release productivity numbers that are expected to show that the productivity miracle of the recent past was somewhat less miraculous. Rising productivity - the ability to turn out more without adding costs - was a key reason for investor optimism. ''The productivity revisions will be nasty for the equity markets,'' said Allen Sinai, chief economist at Decision Economics.

But investor optimism is hard to kill. Just ask Brian Bruce. Bruce is director of global investments at Panagora Asset Management, a Boston money management firm. Bruce regularly studies the earnings estimates produced by Wall Street analysts. What he has discovered is fascinating.

Analysts, he says, do a pretty good job of adjusting forecasts for the next quarter and the next year in response to news. But they rarely adjust long-term forecasts, typically five-year forecasts. Consider Cisco, an extreme example of what Bruce is talking about. The troubled tech company is expected to see its earnings fall 22 percent this year and another 33 percent next year. Yet the analysts who cover Cisco still put its five-year future growth rate at 25 percent. You think they might be a tad overoptimistic?

Morgan Stanley's Richard Berner thinks the analysts are also too optimistic about their outlook for next year. The analysts who report their numbers to First Call, the Boston company that tracks estimates, expect earnings for the Standard & Poor's 500 to climb 20 percent next year. Berner says a number about half that great would be more realistic.

Allen Sinai is looking for an increase of only 7 percent. As Sinai wrote in a note to clients last week, ''The kind of rebound in profit expected by the analysts for next year simply is out of synch with the economy's prospects.''

The implications for the stock market are clear: If earnings don't come through, then even today's depressed stock prices may be too high. ''There is still potential downside risk,'' wrote Sinai. ''Caution is advised.''

We could not have said it any better.

-- Andre Weltman (aweltman@state.pa.us), August 07, 2001

Answers

That's one thing I've noticed about the stock analysts. They will downgrade a stock by, say, half, sending it plunging. Then for several quarters after that, if their drastically lowered estimates are beaten by as little as one cent, the stock responds, moves back up again, and up and up and up in subsequent quarters, with only the same kind of meager improvement from an abnormally low base. Whoever invented the term, smoke and mirrors, knew what he was talking about.

-- Chance (fruitloops@hotmail.com), August 07, 2001.

The investors of the 1990s are mostly baby boopers. They've never known hardship or a declining stock market. No wonder their optimism is so prevalent, and they are so slow to read wall handwriting.

-- R2D2 (r2d2@earthend.net), August 08, 2001.