The second-quarter profit parade has only just begun, but already it looks as though U.S. corporations have turned in another blockbuster. According to Thomson First Call, analysts are expecting profits to rise by an average of 24 per cent from last year.
If they are right, it will mark the fourth quarter in a row that U.S. corporate profit growth has been above 20 per cent. That kind of streak has occurred only five times in the past 50 years.
So, you'd expect the markets to be celebrating this great feat, right? Just the opposite, in fact. Since the end of June, it's been a downhill ride — and a bumpy one. Nasdaq is down almost 10 per cent, while the Dow Jones industrial average and the Standard & Poor's 500 are lower by almost 5 per cent.
So far this year, the three major indexes have traced an up-and-down pattern marked for the most part by ever-lower highs and lower lows. All three are back where they were last fall. The S&P 500 fell below its 200-day moving average (a key technical indicator of market weakness) this week, joining the Dow and Nasdaq, which have been below theirs for the past few weeks.
As if to reinforce the point, the Dow also slipped below the psychologically important 10,000 mark this week, for the third time this year, which spooks investors.
Why the gloom when corporate profitability is hitting such heights? As always, the markets are a forward-looking mechanism, and they spent most of last year cheering the expected upturn. Now, investors fear the party is nearing the end, or at least likely to slow down.
Mounting evidence arrived recently in the form of disappointing durable goods orders, housing starts, retail sales and job numbers. Adding to the fear this week were lacklustre forecasts from some market bellwethers. Among others, tech heavyweights Microsoft, Amazon and eBay provided what investors saw as weak growth estimates for both the current quarter and the full year. Other major players such as Coca-Cola, Caterpillar and Sears also disappointed markets.
Thomson First Call's outlook for the third quarter is for profit growth of 15 per cent. That's still fairly high, but not compared to 24 per cent. And some forecasts for the fourth quarter and next year are even lower. The average for 2005 profit growth is about 11 per cent, but Merrill Lynch, for one, is projecting less, a 6-per-cent rise.
Why is profit growth slowing? Two reasons: Lower productivity and higher costs. Productivity growth is slowing as firms hire more staff to meet demand; and companies are facing higher input costs. While they can pass on some of those costs by raising prices, they can't pass on all of them.
This view is shared by none other than Federal Reserve Board chairman Alan Greenspan. In his regular address to the U.S. Congress this week, Mr. Greenspan reiterated a point he has been making for several months: The combination of increased hiring and rising input costs such as higher wages will likely put the brakes on corporate profit margins.
Over the past 30 years, the chairman said, the average profit margin for non-financial companies has been about 10.5 per cent, but in the first quarter of this year it was about 12 per cent. According to Mr. Greenspan, that suggests profit growth will start to slow.
In fact, he told Congress, "some levelling or downward pressure on profit margins may already be in train, owing to a pickup in unit labour costs." Last year, Mr. Greenspan said, virtually all of the increase in productivity showed up as higher profits rather than real wage growth, but "what history tells us is that the shift now goes in the other direction."
The picture isn't all bleak. After all, even the most pessimistic forecast still shows profits growing this year and next. But after four quarters of 20-per-cent growth, even a rise in the high single digits doesn't seem like much to celebrate about. In the short term at least, that could keep markets in a funk.Mathew Ingram writes analysis and commentary for globeandmail.com.
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