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Our more bullish readers sometimes question why we're so negative on equities when corporate profits remain extremely strong. US growth may be turning down, but firms are still doing very well, they point out. Just look at the third-quarter average earnings for the S&P500, which are running at a far stronger than expected +17%, even while US GDP grew just 1.6% in real terms.
But there are two problems with taking comfort in those statistics. The first is that corporate profits are lagging indicators they tell us what has already happened. And we already know that we've had a fantastic couple of years for corporate profitability. What we're concerned about is next year and the leading indicators are all suggesting a pronounced downturn, maybe even a recession in 2007.
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The other problem is that the corporate profit growth and GDP growth numbers can't be directly compared as they are usually presented, because they're measured in different ways. Once you put them on the same footing, corporate profits start to look a lot less amazing...
For starters, when we talk about earnings growth, we put it in year-on-year terms. So when we say that earnings in the S&P500 grew 17% in the third quarter of this year, we mean that they are literally 17% higher than earnings in 2005's third quarter.
But with GDP, we look at annualised quarter-on-quarter growth. In other words, we look at how much GDP grew between the second quarter and the third quarter, then multiply that by four to work out how much the economy would grow in a full year if growth remained at that rate.
Secondly, profits are usually given as earnings per share (EPS), particularly in the US. For those who aren't familiar with the term, this is calculated by dividing a company's earnings by the number of its shares in issue. Clearly, there are two ways to grow EPS: you either earn more money (increasing the 'E' in the equation), or have fewer shares (decreasing the 'S'). Therefore, the huge volume of share buybacks that have taken place over the last couple of years can add several percentage points to year-on-year comparisons of EPS.
Thirdly, people tend to quote GDP in real (inflation-adjusted) terms, but earnings in nominal (non-inflation adjusted) terms. We need to compare like-with-like the easiest way is to compare earnings with nominal GDP (3.4% for this year's third quarter).
Lastly, and specific to this quarter in the US, year-on-year earnings comparisons look very good because of the dent that Hurricane Katrina put in many companies' earnings in the third quarter of 2005.
So what happens if you correct for these factors? Merrill Lynch's David Rosenberg has crunched the numbers and the difference is substantial. For instance, he calculates that third quarter earnings actually shrank by 1.7% on the previous quarter, which is a decrease of 6.5% at an annualised rate.
However that overstates the difference if you're trying to compare it to GDP, because GDP numbers are seasonally adjusted. Rosenberg applies the same seasonal adjustment to earnings and comes up with third quarter growth of 8.5%, versus 3.4% growth in nominal GDP.
Although not in the same ballpark as +17% year-on-year, that still looks reasonably healthy. But consider the trend. Using the standard year-on-year figures, earnings growth has been on an uptrend since the third quarter of last year. But using Rosenberg's adjusted figures, earnings growth is decelerating; from around (a Katrina-assisted) +19% in 2005's fourth quarter; to +16% in the first quarter, +14% in the second, and finally to that +8.5% for this quarter.
In other words, just like GDP, US corporate profit growth is falling off fast (for comparison, nominal GDP growth went from +5.1% to +9% to +5.9% to +3.4% over the same period). And as mentioned, this is lagging data; the leading indicators suggest that the slowdown has only just begun.
Turning to the stock markets...
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In London, blue-chip stocks were little changed yesterday. The FTSE 100 closed a fraction of a point lower at 6,149. Consumer goods firm Unilever was the day's clear winner, its shares climbing 6% as Q3 results beat expectations. Healthcare firm Smith & Nephew was the biggest faller of the day on confirmation that it had held merger talks with US competitor Biomet. For a full market report, see: London market close
Across the Channel, shares tracked losses on Wall Street to end the day lower. The Paris CAC-40 closed 68 points weaker, at 6,223. In Frankfurt, the DAX-30 closed at 5,310, a 60-point fall.
On Wall Street, stocks closed lower as data showing that both wage inflation and jobless claims are on the up weighed on sentiment. The Dow Jones recorded its fifth consecutive loss, closing 12 points lower at 12,018. The tech-heavy Nasdaq and the S&P 500 both ended the day a fraction of a point lower, at 2,334 and 1,367 respectively.
In Asia, the Hang Seng hit a new record high today, jumping 34 points to close at 18,749 on the back of strength from China Mobile and the property sector. The Nikkei was closed for a holiday.
Crude oil fell below $58 dollars for the first time in a fortnight in New York yesterday. Milder weather forecast for the US is expected to curb demand for fuel. Crude was little changed this morning, trading at $57.89. In London, Brent spot was unchanged at $55.77.
The price of gold fell by over $1 in Asia trading. Spot gold was last quoted at $622.75, down from $623.90 in New York late last night.
And in London this morning, British Airways announced an 8% fall in second-quarter operating profit. The company's profits, which were in line with analyst's forecasts, were hit by disruption to flights prompted by August's terror scare and its sale of loss-making regional carrier BA Connect to Flybe. Shares in BA had fallen by as much as 1.6% this morning.
And our two recommended articles for today...
What do falling US house prices mean for gold?
- It's now becoming hard to deny that the ailing US property market is exerting a drag on the economy as a whole, says Paul van Eeden. To find out what this means for the price of gold, read: What do falling US house prices mean for gold?
Treasury talk: are bond fund managers right?
- Do bond fund managers know something that other investors don't? Quotes from a recent Bloomberg article on the likelihood of an interest rate rise would suggest that they do. Not so, says Mike Shedlock, it seems that everyone is simply talking up their book. To find out why bond fund managers' predictions range from the ridiculous to the absurd, see: Are bond fund managers right?
Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.
Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.
He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.
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