The recession that began in March 2001 has been termed a corporate
sector recession because of pervasive weakness in the business sector,
in particular business profits and investment.1
Signs of this weakness include higher levels of corporate bankruptcies, higher default rates on corporate bonds, and higher levels of commercial and industrial (C&I) loan charge-offs at FDIC-insured commercial banks. During the second quarter of 2002, insured commercial banks charged off $4.2 billion in C&I loans, the second-highest level of C&I charge-offs on record and 40 percent of all charge-offs in the quarter. Amid recent economic data that do not clearly point to a turn in the business cycle, business analysts naturally look to other measures to try to discern a turning point in business conditions.
Recent earnings reports from companies in the Standard and Poor's
(S&P) 500 index suggest that the trend of declining corporate profits
may have run its course. Using the S&P 500 index as a benchmark is
instructive because it is a broad measure comprised of companies
that are fairly well-known to investors. After five consecutive
quarters of negative year-over-year growth in earnings from
continuing operations, companies that comprise the S&P 500 index
reported positive growth of 1.4 percent for the second quarter of
2002.2
The second quarter earnings performance tended to exceed analyst
expectations. According to Thomson First Call, 421 (85 percent) of
the companies that have reported earnings matched or beat
expectations while 73 (15 percent) fell short of expectations.
Overall, composite reported earnings exceeded expectations by 1.3
percent. Although this performance is low by comparison to the
post--1994 average of 2.8 percent, nevertheless, there are a greater
number of companies matching or beating expectations than the
historical average.
D
Earnings growth in the second quarter of 2002 was led by the
consumer cyclicals (which include automobiles, furniture, and
clothing) and telecommunications sectors (see Chart 1). Demand for
durable goods such as automobiles and auto parts has remained
especially strong throughout the recession. The strong housing
market also boosted demand for housing related purchases such as
furniture and appliances, contributing to strong earnings growth for
the consumer cyclicals. Year-over-year growth in earnings for the
telecommunications sector tended to be artificially inflated because
earnings in the second quarter of 2001 were particularly low, and,
in the case of some sub-sectors, were negative. The worst-performing
sectors included energy and transportation, both of which experienced
negative year-over-year growth. The energy sector was affected by
price weakness in the oil and gas markets, while the poor financial
performance in the airlines industry led to declining earnings in
the transportation sector.
One factor that must be taken
into account when making period-to-period comparisons of S&P
earnings performance is that the composition of companies that make
up the S&P 500 index changes over time. According to S&P Compustat,
sectors that experienced a decline in the share of listings in the
index from 1983 to 2001 include energy, materials, industrials,
consumer discretionary, consumer staples, and utilities. The health
care, financial, information technology and telecommunications
sectors now comprise a larger share of the companies that are
included in the index. Not surprisingly, the information technology
sector has enjoyed the largest share increase in percentage terms
with a 9.4 percentage point increase in its share of the companies
represented in the index. The financial sector comes in second
with a 6.2 percentage point increase.
Future earnings at companies
listed on the S&P 500 index are expected to continue to show
positive growth. First Call currently estimates that earnings in
the third quarter of 2002 will be 11.2 percent higher than a year
earlier, while earnings in the fourth quarter will be 22.9 percent
higher than a year earlier. However, these estimates may be
optimistic in that they follow a string of overestimated earnings
figures. Over the past eight quarters, earnings estimates at the
beginning of each quarter have exceeded actual performance as
earnings for the quarter have been much lower than expected (see
Table 1). It appears, however, that estimates have come closer to
actual earnings performance over the past two quarters. With the
direction of the economy still uncertain and with corporate
financials being more highly scrutinized, it remains to be seen
whether forecasted earnings will become more in-line with actual
performance in the third quarter of 2002 and beyond.
D
According to First
Call analysts, the earnings outlook is highly dependent on
sustained recovery in the economy and demand in key sectors such as
technology, financials, and consumer cyclicals. It is difficult to
see many bright spots in the technology sector, although game
software makers appear to be showing some strength, and business
spending on software grew by 10 percent in the second quarter.
Financial market weakness has hurt some market-sensitive revenues
at many large financial institutions, although a favorable interest
rate environment and a widening of net interest margins have so far
outweighed any negative effects of market weakness.3
Finally, consumer demand for both durable and nondurable goods has
remained strong, sustaining the economy and the profitability of
producers of consumer cyclical products such as automobiles,
furniture, and clothing. However, the ability of consumers to
maintain current spending patterns depends on the resilience of the
job market, future real income gains, and the ability to service
future debt burdens.
Another
measure of corporate earnings is provided from the National Income
and Product Accounts (NIPA) compiled by the Bureau of
Economic Analysis.
This measure of corporate earnings is very different from that of
the S&P 500, and they are not always in sync. NIPA corporate
profits, which include profits of every corporate entity, showed
strong year-over-year growth in the fourth quarter of 2001 and the
first two quarters of 2002, even as S&P 500 profit growth remained
weak (see Chart 2). In the Federal
Reserve Board’s semiannual monetary policy report to Congress,
Chairman Alan Greenspan suggested that some of the historical
differences could lie with stock options because the NIPA numbers
include the cost of stock options, while the listed company profits
do not. Thus, "real" listed company profits may have been
inflated in the late 1990s and 2000. Chairman Greenspan also attributed
the recent strong growth in NIPA corporate profits to strong
productivity gains and declining unit labor costs.
D
The disparity
between the growth in S&P 500 profits and NIPA corporate profits
from 1998 to 2000 may also reflect some of the accounting issues
that have now come back to haunt many listed companies. Economy.com
analyst Michael Burt suggests that, despite the differences in the
measurement of the two earnings figures, the strong growth in S&P
500 profits relative to NIPA corporate profits should have alerted
investors to the potential for inflated profits at S&P 500 firms.
4
Institutions both public and private have been
working on solutions that would help to prevent executive
malfeasance, clarify corporate reporting, and strengthen corporate
governance. For instance, the U.S. Securities and Exchange
Commission (SEC) has required the CEOs and CFOs of the largest 947
listed companies in the U.S. to personally certify the accuracy
and completeness of periodic financial reports.5
Thus far, only a handful of CEOs and CFOs of S&P 500 firms have not
completed this certification. In addition, the recently passed
Sarbanes-Oxley Act introduces far-reaching measures that will limit
the operations of audit firms to reduce potential conflicts of
interest and introduce stricter punishment for corporate executives
who are found guilty of wrongdoing. Finally, ratings agencies have
engaged the analyst community in the debate by introducing more
uniform and representative measures of corporate performance, such
as the S&P "core earnings" concept.6
A recovery in
corporate profits is an essential element for renewed growth in
business investment. As corporate profits begin to grow again,
businesses should have more free cash flow to invest in productive
projects and resources, which would in turn help to spur economic
growth. There are some signs that such a recovery may be taking
hold. Advance data indicate that orders for non-defense capital
goods increased by 13.5 percent in July, suggesting that business
investment may be poised for a rebound. In time it will be easier
to discern what is a real trend and what is simply noise in the
data. In the meantime, though, analysts can continue to focus on
some basic indicators of profitability that could tell us much
about the underlying strength of the U.S. economy.
