Stocks may look cheap now, but a deeper-than-expected U.S. recession and a broad downturn overseas will put pressure on U.S. earnings
You have to admire the optimism of stock analysts. Just don't bet your 401(k) on their profit projections. More than a month into the fourth quarter, industry analysts expect this quarter's earnings per share for the companies in the Standard & Poor's 500-stock index to climb 24.7% from the previous year even as third-quarter profits are headed for a decline of about 14%. They also see earnings for calendar year 2009 rising 13.1% from 2008. Most investors have other ideas, given the gloomy profit expectations they have already built into stock prices. The S&P 500 is off 40% from its October 2007 peak and 25% in only the past two months. The real question, though: Is all the gloom priced in?
Don't bet on it. U.S. companies are entering the toughest earnings environment in decades. The plunge in economic activity in September and October suggests the recession is cutting deeper than expected, meaning even more pressure on top-line revenues. After adjusting for higher prices, domestic sales last quarter were below their year-ago level, and the worst of the recession has yet to play out.
Profit margins have been shrinking for two years, and they are about to get squeezed harder. In many cases, product prices are certain to rise more slowly in coming months than the labor cost of making the product. That's because productivity gains are slowing, as they do in a recession, providing less offset to rising labor costs. Meanwhile, with industrial operating rates already at a five-year low in September, increased market slack will stifle pricing power. That's a recipe for a smaller profit on each item sold.
The pressure on earnings was already intensifying in the third quarter. With 422 of the S&P 500 companies having reported, their earnings combined with expectations of those yet to report are down 13.9% from the year before, according to Thomson Reuters. As has been true all year, the energy sector (up 60%) and financial companies (down 107%) were the big movers. More telling, profits—excluding both energy and financials—are expected to be down 1%, after posting small gains in the two previous quarters. Guidance from companies on their expected fourth-quarter results is getting worse, as implied by the rise in negative pre-announcements on earnings.
Perhaps the biggest hit to U.S. profits in the coming year will come from overseas. Given the greater dependence of American businesses on foreign demand and increased U.S. investment in foreign operations, the global recession and the dollar's new strength will have a much bigger impact on earnings than in the past.
The share of U.S. company profits from overseas business has ballooned from 26% to a record 37% in the past two years. Over that time, the $148 billion drop in overall profits would have been far worse without the $137 billion boost from foreign receipts. Now, with growth overseas expected to be halved next year, exports will suffer greatly, as will sales by U.S. multinationals. The stronger dollar not only will make U.S. exports more expensive abroad, but it also will reduce earnings of overseas affiliates, since those profits will convert into fewer dollars.
Several other factors unique to this business cycle also will take a toll. True, the drop in oil and commodity prices will cut costs, but they will slam the profits of energy and commodity producers as well. They also will depress the bottom lines of companies holding inventory of those goods, as their value is marked down. Over the past year, rising inventory values added $97 billion to book profits. Also, the credit crunch is raising interest costs for many companies, and there's the ongoing process of deleveraging. This elimination of debt, often by the forced sale of assets at less than their purchase prices, is eroding corporate returns.
Based on analysts' upbeat expectations, stocks look cheap right now. But in this harsh business climate, earnings disappointments could extend far into 2009, especially if the economy fails to mount a solid recovery.