Tuesday, October 24, 2006

Which Way Are Profits Going?

It's earnings season on Wall Street, and Barry Ritholtz draws our attention to the way in which corporations are continuing to announce yet another quarter of double-digit profit growth. Barry writes:
My reservations about earnings have been twofold: First, SPX gains have been unusually reliant on energy and materials stocks, accounting for a disproportionate (by some measures, as much as half) of earnings improvements; Given the drop in oil, copper, steel, etc., (at least short term), these companie's contribution to S&P profitability are likely to feel some impact.

Secondly, financial engineering of year-over-year earnings continues via share buybacks. About a third -- 5 of the 15% E gains -- are due to the massive stock buybacks we have seen. According to Merrill Lynches David Rosenberg, this has reduced share count to the point of improving earnings by that third.
He also points us to this NYTimes article:
Comparisons That Make Earnings Look Good

AT first glance, the quarterly earnings season is off to a healthy start, but one analyst warns that there may be less to the recorded growth than meets the eye...
On Friday, the BEA will release the first estimate of GDP for the third quarter of 2006. While interesting in its own right, the data release will also include a first estimate of corporate profits.

During the last peak and subsequent downturn in corporate profits in the late 1990s, companies resorted to a variety of techniques (some legal, and some decidedly not) to be able to continue issuing favorable earnings reports. By 1999 and 2000, when corporations continued reporting strong profit growth from earlier periods, it became clear that something strange was going on, because profits as measured by official government statistics showed that profits had fallen since 1997. The following chart shows the path of corporate profits over the past 20 years.

My question now is this: is this same thing starting to happen all over again? Have corporate profits truly peaked (as they did in 1997), and are companies resorting to creative ways of stating their earnings to disguise that fact? While profits were slightly lower in the second quarter of 2006, having another quarter of data will do a lot to help us get a handle on this possibility. We'll find out on Friday.

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