TCS Daily


What Do Profit Disappointments Mean in a New Economy?

By Kevin Hassett - October 16, 2000 12:00 AM

The Federal Reserve left rates alone again earlier this month, but markets did not celebrate. Nasdaq again was pummeled (despite a comeback on Friday) and even blue chip technology stocks like Amgen (down 21 percent from its high) and Applied Materials (down about 50 percent) are well off their highs. Is it time to worry?

When I start to consider worry as an option, I usually make a list of things that could go wrong and then think about whether they will. In previous Greenbooks, we have discussed what the Federal Reserve is worried about: surging demand might cause prices to soar, and force the Fed to raise interest rates. That road leads to recession (as higher rates choke off consumer spending and business borrowing - and draw dollars away from stocks and into bonds) and bad times for technology firms that are light on cash.

But we have hit a spot in the road where both the old and new economy views agree about inflation. Economic growth---likely chugging along at about 3 percent per quarter right now---is not sufficient to cause much inflation even if you believe the Phillips Curve (the now-repudiated notion that low unemployment inevitably is linked with inflation) is still alive. So why the wild market fluctuations?

Most news analysis has featured profit warnings prominently, and my guess is that this analysis is partially correct. Many firms have indeed warned that profits are lower than expected, and the big market swings have been correlated with the more spectacular of these announcements. Oil prices are higher, and Europe is suffering another currency crisis. If the profit trajectory lowers significantly then share prices should follow.

So is a big drop in profitability right around the bend?

It depends on whether the Old or New Economy view is correct.

If you were unfortunate enough to sit through the typical undergraduate economics course, you may remember that the law of "diminishing returns" figured in much of the analysis of the firm. Companies might create a clever and profitable new product, but unless they can construct a barrier to entry, competitors would quickly clone the firm's idea and compete away the profits. After the process has run its course for a little while, no firm will be earning unusually high profits.

Historically, such a process looks to be a fairly reasonable description of the data. Profit growth (adjusting for inflation) has spiked sometimes, but it has always returned fairly rapidly to its long-run mean of about 2.8 percent---the average since 1929. Competition has constrained firms' ability to increase profits to the sky.

Until recently, that is. In the last eight years something astonishing has happened. Real profits have grown at an annual rate of 8.2 percent per year, about triple the long-run average. Profits have also been consistent. We have now seen nine consecutive years of increasing profits, the longest run in recorded economic history.

How should we react to such positive news?

An Old Economy sage would argue that the first wave of technological innovation has run its course. Efficiency-enhancing new products such as PCs, operating systems, software, and infrastructure were intensely profitable for a while, but now the competition has caught up with the innovators and normal returns are more likely in the future. If that happens, profit growth will return to normal. Diminishing returns will set in.

On the other hand, the information technology revolution may have dramatically increased the speed with which new products are invented. The traditional model is not one of continuous evolution, but that is what the world looks like now. An innovator comes up with an idea that makes lots of profits, and just as the competition catches up, she invents something else even better. If our more successful firms can stay a step or two ahead of the competition, profits and profit growth can stay permanently higher.

Which view is right? Nobody knows for sure, but here is how you can think about the bet you are going to place. If you believe the Old Economy view, you should clearly buy indexed bonds, which have a high yield now (about four percent plus annual inflation) and relatively low risk. This bet will be the best if ten years from now consumers are consuming pretty much the same bundle of products we are consuming today. Profit growth will be very disappointing, and so will equity returns. If, however, you believe that the things you spend your money in a decade are not even invented yet, buy more equities right now. There is a great sale going on.

Consider Applied Materials, the maker of chip-manufacturing equipment. After dropping almost by half in price, the stock's P/E ratio on earnings expected this year is only 22 (or a little lower than the market as a whole) - this, for a firm that has posted earnings growth of 20 percent annually over the past five years. The average analyst forecast for future growth over the next five years is 25 percent annually. If the New Economy view is correct, that is probably an underestimate, as computer chips will find their way into more and more devices, putting enormous strain on fabrication capacity. But even if the analysts's estimate is correct, and the stock's price doubles, then the P/E five years from now will be about 14, a little less than the average P/E over a U.S. history where real profit growth was one third that of recent experience. Makes buying now seem pretty smart, doesn't it?

And where do all of the profit warnings fit in? My guess is that higher oil prices are eating into margins, and lowering profit targets a bit. Old Economy mavens are hooting "I told you so" and selling stocks, but they are missing that fact that a supply shock, rather than increased competition, is behind the swing in profits. We have not learned anything that implies that tech profits will be lower over the next ten years than we thought a few months ago. The latest dip is just another buying opportunity for those willing to consider the possibility that we are living in a changing world.
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