profits......

[Eubulides <paraconsistent@xxxxxxxxxxx>]

http://www.economist.com/
Buttonwood
What's puffing up profits?
Jan 27th 2004
>From The Economist Global Agenda

Investors are seeing what they want to see in the corporate-profits
picture

THERE you are, trying to map-read your way to somewhere you've never been
to, having already taken an unconscionably large number of wrong turns,
and every other minute daughter number two asks how long it will be,
exactly, until we arrive. And then, at last, there is a road that you
recognise, and everyone is again wreathed in smiles. Buttonwood has been
having similar troubles with the American stockmarket, with the added
complication that not only is the map unfamiliar and difficult to read,
but it keeps changing. It is not a market that he likes especially, though
it is popular anyway for reasons that are largely unconnected with value.
But the terrain is becoming familiar again: Buttonwood recognises
irrational exuberance when he sees it.

Some 140 companies in the S&P 500 are due to announce their results this
week. Doubtless they will be cheeringly good: those that have already done
so have beaten analysts' expectations by some 6%, and there is little
reason to suppose that the rest have done worse. But then they will need
to be good, so high are investors' expectations. Stockmarkets have already
climbed a long way from their lows in March of last year-the S&P is up by
44%, and Nasdaq by 69%; and judging by all the available indicators of
appetite for risk, investors expect more of the same. A lot more, in fact.
But how much will profits have to grow to drive stockmarkets still higher?
And how sustainable is this surge in profits?

Investors are certainly gluttons for risk at the moment. There are any
number of ways of measuring this. Most risk-appetite indicators look at
the performance of risky assets, such as corporate or emerging-market
bonds. These have flown, and risk indicators are correspondingly high.
Perhaps the simplest way of discerning appetite for risk, however, is to
ask fund managers how much risk they are taking. This is what Merrill
Lynch has done in a monthly survey since the beginning of 1999. The latest
results are striking. In the ten months since March of last year, when
risk appetite among investors was the lowest the firm had recorded,
appetite has climbed to the highest the firm has seen-higher even than
during the euphoric months before the stockmarket bubble burst in March
2000. Buttonwood has said it before and he will say it again: if things
can't get better, they can only get worse.

There is certainly plenty of scope for disappointment. Investors have very
little in cash; they hate Treasuries almost to a man (two-thirds of
respondents think they are overvalued); and most think that shares are
fairly valued, with prices likely to be propelled further upwards by
higher profits. On this last question, a dose of scepticism is in order.
Last week's column looked at the astonishing profitability of American
financial firms. Citigroup, to take one example, made more money last year
than any company has ever made, and financial firms make up about a third
of corporate profits, which is unsustainable. A bigger question is whether
profits for non-financial firms are also being temporarily flattered, to
which the answer is: most probably.

Profitability, it is true, seems to have been boosted by cost-cutting,
which has allowed any growth in revenues to flow straight to the bottom
line. There are, however, limits as to how much cost-cutting can drive
future profit growth. To push profits up further, demand has to rise-in
the jargon, companies need to boost top-line growth. In America, this is a
problem. It requires the public to spend more than the huge amount it
already spends. Yet America's savings rate is anyway a niggardly 1.7%, and
it seems unlikely that it can fall much further given how indebted
Americans already are.

Perhaps demand would grow if job growth were not as anaemic as it
apparently is, since more people would have money in their pockets. But if
jobs do start to flow more freely, firms would presumably have to spend
more to keep hold of treasured employees. Wall Street provides a nice
example. Heartening though it was for its firms to have made record
profits last year, this was at the expense (if that is the right word for
an industry not known for its parsimony) of its employees. Were Wall
Street's finest to be paid more, profits would fall.

How about foreign demand? The fall in the dollar should clearly have been
a boon, both by making exports cheaper and by increasing the dollar value
of goods that American companies sell abroad in strengthening currencies.
But the actual amount of goods that American companies are exporting has
not risen that much-much of what America exports is not that sensitive to
currency movements. And a rise in the dollar value of widgets can make
foreign demand seem stronger than it is.

This is especially evident in the market for high-techery of one sort or
another, shares in which are, to put it mildly, generously valued. In
fact, IT spending around the world, though rising, is certainly not
soaring, though it appears healthier than it is because of the effects on
revenue growth of a falling dollar. In general, companies are making do
with the technology they already have. Moreover, unless the dollar
continues to fall, the effect on profits will fade. And the truly
astonishing thing is that, despite the falling dollar, the anyway low
proportion of profits earned overseas fell from 21% in 2001 to 14% at an
annual rate in the third quarter of last year, according to the Commerce
Department.

A much bigger (though much less talked about) source of profits has been a
fall in the corporate tax rate. In the third quarter, according to
estimates from Smithers & Company, a research firm, the rate was some 25%.
>From 1990-2000 it varied from 35-40%, but fell sharply after September
11th 2001, because companies were allowed to accelerate the depreciation
of their assets for tax purposes. The mechanics of how all this works are
complex, but the effect on profits is not: they have been hugely
flattered. In the third quarter of last year, after-tax profits would have
been a fifth lower at an annual rate had there not been this allowance and
assuming a corporate tax rate of 40%. The allowance is due to run out at
the end of this year.

As in the late 1990s, however, investors are seeing what they want to see.
And what they want to see is their risk-taking rewarded and a nirvana in
which corporate America, cleansed of wrongdoing and excessive debt, can
get back to the business of making lots of money. Share prices reflect
this-but there's a long way to go yet.