TCS Daily


By Kevin Hassett - May 14, 2002 12:00 AM

With economic growth in the first quarter of this year topping five percentage points, just about everyone now agrees that the recession is over. In the past, such news has had a tremendously positive effect on the stock market. This time, however, investors have become even more jittery as the good news has rolled in. What's bugging the market?

To jump to the punch-line, the market is beginning to come to grips with a very real fear, that corporations have permanently lost the ability to post high profit growth. If that fear is realized, lower prices would be a logical next step.

Why the sudden fear of a dramatic sea change? A look at history helps put the problem in perspective. As mentioned in this space several times in recent months, profits in the most recent recession were worse than profits in just about any other downturn in U.S. history. While the economy coasted through a shallow recession, firms were hammered. Why did profits turn down so sharply? One explanation was that the boom led to excessive investments, and that the resultant huge excess capacity was the culprit.

This story, however, doesn't add up. Over the past few weeks, we here at TechCentralStation collected a dataset of more than 5000 U.S. firms and analyzed the extent to which their disappointing profits in 2001 could be explained by decisions that firms made in prior years. For example, did firms that invested the most in high-tech equipment in 2000 have the biggest declines in profits in 2001? We found no support in these data for the view that excessively optimistic investment caused the problem. Some firms with big negative profit surprises had very low investment in 2000. Some had very high investment. No discernible pattern was present.

But the story does not end there. We went on to ask ourselves, if investment did not explain the negative profit shock, what did? On this, we found only frustration. Every economic theory that we could contrive to explain why firms were hemorrhaging money was rejected in the data. It was as if some mysterious exogenous vacuum swept over U.S. firms and took away their money. This force hit just about everyone, regardless of their circumstances.

Which brings us back to the stock market's jitters. So far, it looks like this vacuum is still plugged in and running. Take a look at past profit recoveries, for example. In 1971, profits grew at 24 percent after they troughed in the fourth quarter of 1970. They grew at almost the same rate after the trough of 1974. After the 1980 recession, profits grew 26 percent in the first two quarters after turnaround began. In 1982, profits zoomed out of the recession 34 percent in the first two quarters. Only in 1990 did we see flat profits after the end of the recession, but back then, profits hardly dropped during the recession. This time around, profits have dropped slightly after the end of a recession where they plummeted. Such a circumstance is unprecedented.

So what is going on?

As mentioned above, the firm-level data do not provide any clues. Just about every firm was hammered, regardless of their circumstances. So all that we can do is propose a theory. On that, I have heard two that might explain what's going on.

The first idea is that the age of the big profitable firm is nearing an end. One of the potential side-effects of an increasingly integrated world marketplace is that it is much more difficult to defend your turf against would-be competitors. Companies can steal your customers on the Internet. They can do the same to your workers. Because of these forces, we are experiencing a gradual decline in the ability of firms to sustain and grow unusual profitability. Because these forces depend on network effects, they could easily jump precipitously in a few short years, and perhaps explain the inability of firms to acquire pricing power, even while the economy is booming.

If such a dramatic shift occurred, it would be very difficult to detect. Profits would disappear from all types of firms, and almost nothing that we have used to traditionally track the quality of firms would be a help to predict the decline in profits. But the circumstance would gradually become evident to observers during a boom because profits would not keep pace with the surging economy.

The alternative story is far rosier, and goes like this. Suppose that accounting firm have become permanently more conservative about what they are willing to label a profit because of the Enron crisis. Every possible expense that was buried in some footnote in the past has been pulled forward into today's earnings. If this is true, then there might be a few bad quarters while the adjustment occurred, but after that profit growth would return to normal.

Clearly, the stock market does not believe either story yet. The relatively stagnant share prices are perhaps best described by a market that has factored in a chance that each story might be true. But as the data roll in over the next few months, we are either going to see a profit recovery of the same scale experienced in the past, or a further run of bad profit reports. In other words, one of the stories is going to be supported by the next few ticks of data, and the other story discarded. Such is the uncertain world that the new economy has thrust upon us.

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