"GULP" IS RIGHT :

The Recovery's Soft Underbelly (Robert J. Samuelson, May 1, 2002, washingtonpost.com )

When it comes to profits, we've had a social revolution in the past 15 years. Before that, only corporate and Wall Street types discussed anything so crass as profits. The Great Bull Market changed us. Profits have joined sports, celebrities, sex and politics as water-cooler and Internet chitchat. People watch stock prices and wait for earnings (profits) reports. We've democratized talk about profits and, in the process, have learned two lessons: First, a strong economy requires healthy profits; and, second, profit reports seem more mystifying and less trustworthy.

We can't ignore those lessons now, because if the economic recovery has a soft underbelly, profits would seem to be it. In the first quarter, U.S. gross domestic product (GDP) -- the output of goods and services -- rose at an impressive annual rate of 5.8 percent. But if profits don't revive, the recovery may be weak or stillborn. Without higher profits, companies won't have the funds to finance new investment in factories, software or machinery. Profits also underpin stock prices. Poor profits may mean a poor market, dragging down consumer confidence and spending.

Given the ramifications, the present profits picture seems grim. Both sources of profits figures -- the government and companies -- show big declines. The Commerce Department reports that after-tax profits of U.S. companies dropped 16 percent last year to $482.5 billion from $573.9 billion in 2000. The decline began in the last quarter of 2000. Measured from there to the end of 2001 -- and using quarterly statistics -- the decline is 27 percent. But that's still not as large as the drop in company-reported profits, expressed as earnings per share. In 2000 the reported earnings of firms in the Standard & Poor's index of 500 companies were $50 a share for the entire index. In 2001 earnings tumbled 51 percent to $24.69.

Consider the implications for the stock market. Since 1950 the average price/earnings ratio (P/E) of the S&P 500 has been 16, says S&P's Howard Silverblatt. A dollar of earnings results, on average, in a stock price of $16. The S&P index is now about 1100. Divide that by earnings of $24.69, and the result is a P/E of almost 45. Gulp. The market is counting on a rapid rebound of profits. Investors aren't buying on the basis of today's earnings but on the much higher earnings expected for 2002 and 2003.

As Stuart Taylor is to the law, so is Robert Samuelson to economics. Not only is he consistently fair, he's actually readable and comprehensible too. This column explains in clearest terms why the economy, or the market at any rate, may be more rickety than it appears. Posted by Orrin Judd at May 2, 2002 12:47 PM