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Generational Dynamics Web Log for 31-Aug-06
Corporate profit growth slowed substantially in second quarter

Web Log - August, 2006

Corporate profit growth slowed substantially in second quarter

This may be the start of the long-term "mean reversion" cycle that readjusts corporate earnings substantially downward.

Wednesday's Commerce Dept. report on Gross Domestic Product shows that GDP growth was at 2.9%, down from 5.6% in the first quarter, though not by as much as economists had expected.

But the most important news in the report is the substantial drop in the growth of corporate profits, according to Steve Liesman, CNBC analyst.

"It's a dramatic decline, 2.1% versus 14.8% in the prior quarter," says Liesman.

(If you're looking for these numbers in the Commerce Dept. report referenced above, then go to Table 11 on page 13 in the PDF file for the report, and look for the line, "Profits after tax with inventory valuation and capital consumption adjustments.")

Steve Liesman <font size=-2>(Source: CNBC)</font>

Steve Liesman (Source: CNBC)

"Here's what's important about this," he added. "In my days at the Wall Street Journal, I was following this number." He said that the changes in this number predicted the Nasdaq crash in 2000. "This series peaked out in 7/98, but the market went on [with the 1990s bubble] for another two years, with what turned out to be 'false profits,'" indicating that a lot of the claims of corporate profit in 1999 and 2000 were "made up figures."

He said that 2nd quarter fall to 2.1% indicates, along with the collapse of the housing bubble and changes in oil prices, that the stock market should start feeling negative effects. "Some portfolio managers trade on this number, and it's a bear signal for them when it starts to decline," he added.

In fact, the fall in corporate profits is a signal that's been expected for a long time.

As discussed last year in an article entitled, The 11% Solution: An article in Barron's says the stock market is very overvalued, analysis shows that corporate earnings have substantially exceeded historical averages for since 1995. Investors have been assuming that earnings would continue grow at the same historically high rate. As we explained in detail, this cannot happen. In fact, by the principle of "mean reversion," earnings are going to fall substantially, to historically low levels, for several years, in order to compensate for the years of historically high earnings. This will trigger a stock market crash similar to the one that began in 1929.

Thus, a substantial fall in corporate earnings growth is way overdue, and it now appears that it began in the second quarter.

Steve Liesman then became very somber, and said something very weird:

"If profits come down, you could make a decent argument for multiples coming up. It's all about ME (multiples expansion). Multiples have been in the 14-15 range. You could make an argument they should be in the 17-18 range. You guys out there have to work the numbers -- figure out what a lower profit outlook combined with perhaps a higher multiple might look like to stock values."

Let me explain what this statement means, and why it's so bizarre.

First, when he talks about "multiples," he's talking about price/earnings ratios, where the price of a stock can be measured in terms of number of multiples of the corporate earnings per share of stock. So, for example, if a corporation makes $1.00 in earnings per share of stock, and the price of the stock is $20.00 per share, then the price/earnings ratio is 20, and the price is a multiple of 20 times the earnings.

As I've written many times in the past, the trick to this computation is to compute the earnings per share. It's easy to compute the price of a share of stock -- just look it up in the newspaper. But corporate earnings can be measured in various ways: earnings in the last year (the most common method), average earnings in the last ten years, or "forward earnings" (analysts' estimates of next year's earnings).

There's a chart that appears on the bottom of the home page of this web site. It's automatically updated every week, and it shows the average price/earnings ratio for the S&P 500 stocks The chart for August 25 (last week) is as follows:

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 25-Aug-2006. <font size=-2>(Source: MarketGauge ® by DataView, LLC)</font>

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 25-Aug-2006. (Source: MarketGauge ® by DataView, LLC)

As this chart shows, stocks have been way overpriced since 1997 (actually, since 1995), and that's another reason why stock prices will have to fall substantially.

But this chart also shows that the current average p/e ratio is NOT 14-15 as Steve Liesman claims, but is actually 17-18. Why the difference? That's because Liesman is using FORWARD earnings. He's using the assumed earnings for next year, computed by assuming that earnings will continue to grow at the same rate. As I've explained several times on this web site, this not only fraudulent, it's moronic. These people use forward earnings to compute p/e ratios, and then they compare that to historical averages using previous year's earnings. The result is a complete mismatch, designed to make the market appear better off than it is.

I hope when this is all over, a lot of these analysts and financial advisors and journalists are held to account in as punitive a way as possible. These people are using obviously incorrect data in order to make more money for themselves. I guess I shouldn't just pick on Steve Liesman, since he's just doing what everyone does. A financial advisor who told the truth would not have any clients willing to buy stocks, so the financial advisor wouldn't make any commissions; so financial advisors are financially motivated to lie, and this trick with the p/e ratios is one way they do it.

Now look at what Liesman says next: "You could make an argument they should be in the 17-18 range. You guys out there have to work the numbers -- figure out what a lower profit outlook combined with perhaps a higher multiple might look like to stock values."

He knows the consequences of falling profits -- that the stock market is going to tank. He just said, a minute earlier, that some portfolio managers trade on this number, meaning that when it goes down, they're going to sell.

He's advising these people to use even more fraudulent computations -- to modify the formulas in their models to accept higher multiples, or p/e ratios -- and so continue to support the overpriced stock market.

Well, I shouldn't keep getting worked up over this stuff. These analysts, journalists and advisors are just out for themselves, and they don't really care what they say.

From the point of view of Generational Dynamics, we're entering a new 1930s style Great Depression, as I've been reporting since 2002. Ten years of high corporate earnings have been based on stock market bubbles and other bubbles that have occurred during that period. Now that the housing bubble has burst, and the housing market is collapsing faster than economists expected, the "corporate earnings bubble" is set to collapse next. This is all related to the generational patterns triggered in the 1990s when the generation of senior financial managers with personal memory of the horrors of the 1930s Great Depression all disappeared (retired or died) all at once, leaving behind new generations (Boomers and Xers) with little or no instinctual ability recognize risky investments. The time is fast approaching when the bill for the last 12 years is coming due. (31-Aug-06) Permanent Link
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Generational Dynamics Web Log for 31-Aug-06 Corporate profit growth slowed substantially in second quarter

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Generational Dynamics Web Log for 31-Aug-06
Corporate profit growth slowed substantially in second quarter