Not Just Me

Some visitors to Financial Armageddon (and other sites where my posts are republished) have questioned my assertion that the widely reported rise in corporate profits won’t lead to a boom in hiring. As I noted in “Simply Deluding Themselves,” those burgeoning bottom lines stem from

companies cutting payrolls to the bone and freezing or slashing spending (e.g., R&D) that is essential for creating sustainable growth (and a demand for permanent full-time workers).

It’s not just me that feels this way. Several mainstream commentators, including Barron’s columnist Alan Abelson, have also poured cold water on the view of many “experts” that these numbers reflect an improvement in underlying conditions. In his latest Up and Down Wall Street column, “A Surfeit of Worries,” Abelson notes that strength in corporate profits

has been achieved by dint of ferocious cost-cutting, aided in the case of the financials by forgiving accounting, zero interest rates and problematic paring down of loss reserves. As gimlet-eyed Dave Rosenberg of Gluskin Sheff notes, although corporate earnings continue to rise—they were up 11.5% in the third quarter—the gains are coming somewhat more grudgingly. That 11.5% compares with 13% in the second quarter and a smashing 49% in the opening three months of the year. Moreover, the rise in domestic nonfinancial profits slowed dramatically, to an 8.6% annual rate, from 25% in the second quarter and 82% in the first.

Domestic profits of financial outfits shot up a decidedly unshabby $33.3 billion in the July-September stretch, compared with a decline of $3.4 billion in the prior quarter. But, as intimated, there’s something a tad hokey about the surge, powered to some significant extent, as Dave describes it, by loan-loss-reserve draw-downs and the steep yield curve.

Cost-cutting is virtuous but it also has its limits, and we suspect the overwhelming majority of companies is within a shrimp’s mustache of those limits. In like vein, even the most skilled practitioner of accounting legerdemain in the fullness of time runs out of tricks.

Absent any swift acceleration of the economy, which doesn’t seem likely, that suggests the explosive rise in corporate profits may be cresting. Now, if you’re of a bullish bent, there’s a worry worth fretting about.

In fact, it’s not a stretch to think that today’s allegedly healthy profits are likely unsustainable. Even though analysts expect earnings from U.S. stocks to reach record levels next year, the Financial Times notes in “Revenue Concerns Temper Record Earnings Forecasts,”

there are concerns that momentum could falter…because revenues are not growing as rapidly.

Margins have been boosted by stringent cost-control and high labour productivity.

This means many more companies are beating expectations on the bottom line than are surpassing top-line forecasts.

“We’ve grown earnings so far mainly by fairly vicious cost-cutting but you can’t cost cut your way to prosperity,” said Ed Cowart, portfolio manager at Eagle Asset Management.

The report adds that the

average S&P 500 profit margin, excluding financials, has already hit the peak that it reached in June 2007. “It’s as good as it gets,” said [RBC Capital Markets chief institutional strategist Myles] Zyblock.

With margins stretched, companies will need to increase revenues faster if they are going to continue to report record earnings.

To spur on revenues, they will need stronger economic growth. In the third-quarter earnings season, which has just drawn to a close, 76 per cent of companies beat profit expectations but only 61 per cent beat revenue forecasts.

All of this assumes, of course, that the profit numbers paint an accurate picture of reality, both in terms of corporate America’s bottom line and how conditions on the ground, especially here in the U.S., are influencing those numbers. In “The Real Story Behind Those ‘Record’ Corporate Profits,” Harvard Business Review blogger Justin Fox suggests that may not be the case.

Pre-tax domestic nonfinancial corporate profits — a mouthful, but also seemingly a fair measure of the underlying health of business in America — are nowhere near record levels as a share of national income. They exceeded 15% of national income once in the late 1940s, and repeatedly topped 12% in the 1950s and 1960s; in the third quarter of this year, they were 7.03% of national income.

This might go some way toward explaining the seeming disconnect between booming corporate profits on the one hand and a very cranky business community on the other. For much of the business community, profits aren’t that high by historical standards. These people have every right to be cranky.

Who is doing better? Well, according to the BEA’s data, financial industry profits and “rest of world” profits — that is, the money U.S.-based corporations make overseas — are relatively much higher now than they were in the 1950s or 1960s. And the taxes paid by corporations are much lower now than they were then, as a share of national income.

So the reason that corporate profits are near their all-time highs would appear to be that financial corporations (mainly big financial corporations) and multinationals are making lots of money and paying less of it out in taxes. Hmmmm.

Leaving all of this aside, there is still the question of intent — that is, are corporate managers actively contemplating increasing their payrolls. Based on the following Financial Times report, “Companies Awash with Cash Still Fear the Worst,” that seems to be one of the last things on their minds.

“I can see our next problem,” the chairman of a large multinational told me the other day. “It will be this: ‘What are you going to do with your cash?’”

His company is swimming in cash barely two years after it stared into the abyss during the worst of the crisis. He could sense that if many more months went by without big acquisitions or new investments, shareholders would agitate for special dividends or share buy-backs – anything to make use of the cash sitting in the company coffers.

He seemed determined to fight. “We have to focus on where we could be in five years’ time, and we aren’t going to get ourselves a stretched balance sheet again. Surely having a lazy balance sheet for a while should be acceptable.”

He is not alone. Corporate chieftains the world over have lots of cash, and want to hold on to it. It is a critical symptom of a new Age of Anxiety, as the corporate world tries and fails to convince itself that the global financial crisis has blown itself out. As Richard Dobbs, head of the McKinsey Global Institute, puts it: “Companies are uncertain about where the world is going to go. Until they are sure, they don’t want to pay the money out.”

So much for the latest bit of “good news.”