The Economy -- Keep the Faith

Dec. 21, 2004
Weakness in third-quarter profits only temporary.

The October nose dive in the stock market was caused by two factors: increased tensions in the Middle East and disappointing third-quarter profit figures. Neither I nor anyone else knows how the Israeli-Palestine problem will eventually be resolved. However, it can be said with greater assurance that the drop in third-quarter profits is only temporary. There is no question that the economy weakened substantially in the third quarter, which would automatically put a crimp in profits growth. In addition, the stronger dollar depressed earnings from foreign sources. Higher oil prices are generally a wash -- as long as interest rates remain stable -- because the drop in manufacturing and transportation profits are generally offset by higher profits in the energy sector. By definition, profits are equal to sales minus costs, plus or minus adjustments for natural disasters such as hurricanes, and fudge factors added by accountants. At the macro level, aggregate profits usually can be tracked closely by linking them to real growth, inflation, interest rates, the value of the dollar, and stock prices. Over the four quarters ending in 2000's second quarter, the Commerce Dept.'s Bureau of Economic Analysis says economic profits, i.e., profits adjusted for economic depreciation and inventory profits, have risen 14.6%. A simple function relating percentage changes in profits to the variables listed above generated an almost identical estimated rise in profits of 15.1%. Hence firms have shown no attempt to overstate the actual recent gains in profits. I think real growth fell to 2.5% or less in the third quarter. Using the values for stock prices, interest rates, the value of the dollar, and inflation that actually did occur last quarter, this estimated function indicates a 1.5-percentage-point drop in profits for the third quarter. That figure is on a seasonally adjusted basis at quarterly rates. In terms of comparison with year-earlier figures, profits rose 13.8% the previous three quarters, so if that 1.5 percentage point is subtracted, that still leaves a 12.3% gain over year-earlier levels. While bad-news profits generally get reported first, it seems almost impossible that such a lofty gain will actually be realized. It is much more likely that reported profits will show less than a 5% gain from year-earlier levels, which means about an 8-percentage-point drop in seasonally adjusted earnings from the second to the third quarter. The reason for presenting this arithmetic is to show that firms have now, as in the past, used the excuse of a weak third quarter to write off everything except the kitchen sink, thus clearing the stage for above-average profit gains in future quarters, a common practice when profits would be disappointing anyhow. The banking industry is a prime example of the use of discretionary write-downs in the third quarter. All of a sudden they have discovered some bad loans on the books. Of course those loans have been there for several years, but no need to alarm the stockholders when times are good. However, when the economy weakens, stock-market profits decline, and disappointing earnings reports are the order du jour, what better time than to write off these festering loans? Hence I think the decline in profits for the third quarter is substantially overstated. Unless the economy does head into a recession because of Middle East tensions, which still seems extremely unlikely even given the escalation that occurred earlier in October, that sets the stage for a major rebound in profit growth starting this quarter. As this generally becomes known, the stock market will rebound in tandem. Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill. His e-mail address is [email protected].

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