Hamish McRae: Upswing in the world economy will depend on recovery in profits

We have witnessed the worst decline in US profits in history, a fall of more than 40%
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The Independent Online

Profits, not prophets – those are what the world economy needs.

Profits, not prophets – those are what the world economy needs.

The current anguish about the nature of the recovery – yes, there does seem to be one but it is far from secure – will diminish once the outlook for company profits looks up. Share prices are still quite high by historical standards, especially on the other side of the Atlantic, and another share price collapse would undermine consumer confidence and hence demand. That, so this argument runs, is the greatest danger now threatening the world economy.

But once company profits start being revised upwards, instead of down, the present share price levels begin to look more reasonable, especially in a low inflation/low interest rate environment. Will the profits come through in time?

Stand back for a moment. Downward revisions of profits have been much more marked in the US than in Europe. This is partly because they were over-inflated in the first place and partly because, post-11 September, companies and analysts alike have had an excuse to rewrite the books.

The result has been the worst decline in US profits in history, as the top right-hand graph shows. Right through from 1950 to 1990, the typical decline in earnings per share associated with recession was 20 per cent. In the early 1990s recession, though a very short one, the fall was a bit worse. But what has happened now, a fall of more than 40 per cent, has not happened for 50 years. During the last quarter of 2001 the big US companies collectively lost money, thanks partly to weak running earnings but more to a series of large write-offs. On an annual basis this is the largest fall since 1942. I have not checked what happened in the 1930s but those circumstances were so different that you could say that this collapse is the worst peacetime hurricane of the century.

As a result price-earnings ratios have shot up. They were pushing it at about 30 but now, for the S&P 500 companies they have gone up to 60. This is astounding. It is overvaluation on a Japanese scale circa 1990 – numbers that can only make sense if there is a strong and swift boom in US profits.

The view of the market is that this is exactly what will happen. This is, in the words of the independent economic analyst Don Staszheim, "the dark before dawn". There will, he predicts, be a sudden surge in profits. They have gone back so far that mathematically the only way they can go is up, and a 50 per cent boost is the worst he can imagine. Even going back to the 1993/5 pre-bubble average would result in a 58 per cent gain. Trouble is that isn't enough to bring share prices back to a reasonable level by long-term historical standards. Profits have to return double-digit gains for three or four years for shares to begin to look cheap by past p/e standards.

Maybe that will happen. One of the functions of recession is to push companies into becoming more efficient and this certainly seems to be happening in the US. Productivity seems to have continued rising through the recession, which would be pretty remarkable – it is much easier to get productivity gains when you are increasing output than when you are cutting it. The US corporate sector appears to have been so shocked by the sudden and savage recession it has been questioning every aspect of its activities in an effort to lift productivity. But it is asking a lot to produce double-digit increases in profits in an economy that is only growing at, say, 3 per cent in real terms and, say, 5 per cent in nominal. In fact it cannot happen for, at some stage, the share of profits in total GDP has to stabilise.

This leads to two further considerations. The first is the extent to which US experience is applicable to Europe, including the UK; the second whether p/e ratios remain the appropriate benchmark. A couple of points on each.

European and UK companies were less highly rated than those of the US ahead of this last surge in US p/e ratios. In both cases, too, the downgrading of profits has been less savage. You can see the way in which prospects for 2001 profits of European (including UK) companies were steadily downgraded through last year from the bottom left-hand graph. Downgrades for 2002 have been less severe and in recent weeks have started to look much better.

Now, of course, if profits for year A fall by 20 per cent, profits for year B have to rise by a larger percentage (because they are on a lower base) just to get back to the number at which they started. The result, as ABN Amro points out, is that the year-on-year consensus forecast for profit growth in 2002 is now 20 per cent. But the bank also notes that the main reason for the fall in profits last year was goodwill write-offs, a pattern that is likely to continue. We are not through the woods yet.

As a result the mood shifts from day to day. We are in the middle of the reporting season and two or three good results will perk the market up, while a couple of bad ones will thump it back down. Expect this twitchy mood to continue.

The not-very-scientific conclusion from all this would be that in mood terms, Europe and the UK is very similar to the US. While the numbers may appear less demanding, it would be naive to assume that were the US market to head seriously backwards, European markets would escape.

What about the measure of p/e ratios? The main alternative is the bond-equity yield ratio: what can you earn from equities set against long-term bond yields? After all, bonds are the main alternative investment to shares. The results for large, medium and small UK companies are shown in the final graph, from Merrill Lynch.

One obvious point here is that you can still buy more value in smaller companies than in large, though there has been a notable narrowing of the gap. That you would expect, for they are less liquid, take more time to research, and are not so attractive to giant global investors. But the overall ratio, for all types of company, is now at pre-bubble levels. Equities as a whole are not materially bad value or good value vis-à-vis bonds by recent historical standards. In short, there is no flashing amber warning light on this particular measure, unlike the p/e one. Essentially what has happened is that gilt yields have come down so much over the past four years that returns on shares look OK again.

My concern, and this comes back to the question posed at the beginning, is that the bond-equity yield ratio also requires companies to return to making decent profits. The fashion is now for investment in bonds, particularly for pension funds, and unless companies can get back to a smoothly rising flow of earnings, that fashion will intensify. Big funds switching from equities to bonds will undermine an already fragile market.

The answer, of course, is for companies to make some profits. Simple, innit?