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Market bottoms first, profits rise later

  In the situation of widespread recession over the past two years, the performance on the stock markets has been especially negative. The emblematic S&P 500 index showed a cumulative drop of nearly 60% between October 2007 and March 2008. The profits of those companies making up that index were down by an even greater proportion, specifically 82%(1) between the second quarter of 2007 and the fourth quarter of 2008. The financial nature of the crisis was a determining factor in reaching those spectacular figures, given that the banks have suffered massive losses because of the depreciation of so-called «toxic assets». The big unknown is how to work out if the adjustment in profits and equity prices may have now ended.

  As may be seen in the graph, profits have historically swung around their age-old tendency although since the Thirties we have not seen such sharp changes as those in the present cycle. In the summer of 2007, corporate profits in the United States stood at especially high levels. Since the end of the 2001 recession, growth of profits showed very high figures of around 20% annual. The contribution of the financial sector was very important, the result of major growth in mortgage loans by commercial banks and the sharp increase in risks taken by investment banks. The proportion of financial profits(2) over the total for all sectors of the economy reached 45% in 2001 and later stood at 33%, notably above the historical average, as may be seen in the second graph on the next page. In other sectors, the growth of profits was also notable largely thanks to increased financial and operating leverage by companies.

  In the last two years of the upward period (2006 and 2007) there arose a whole series of pro-cyclical factors, such as growth of production at the international level, the historical drop in risk premia and the containment of interest rates, broad programmes for repurchase of shares set up by companies and a big increase in remuneration formulas in favour of book profits, such as stock options and pension funds.

  Some signs of weakness could be noted in the profit and loss accounts of companies even before the harsh blow at the end of 2008. In fact, the worsening of profits began some quarters before in non-financial and non-energy companies, as may be seen from the drop in margins brought about by the sharp rise in commodity prices and the increased cost of credit (the construction sector was one of the first to get into difficulties). Later on, with the worsening of the financial crisis in the Autumn of 2008, the huge write downs in bank balance sheets brought about an historical drop in profits in the financial sector. Finally, those companies with the greatest exposure to the foreign sector that had managed to maintain a high level of profits for some time longer thanks to their foreign subsidiaries, suffered in the last quarter of 2008 and the first quarter of 2009 the consequences of the internationalization of the crisis.

  The downward cycle in profits, both in its moderate and quiet initial stage and in the spectacular losses of the financial institutions, was not adequately foreseen by financial analysts. The development of a feed-back boom in the economy and the markets from 2003 to 2007 produced an inertia among analysts and investors that sent many forecasts and valuations to extreme levels.

  In financial circles people were ready to ignore figures for over-borrowing by households and many companies. The latter were even rewarded in the markets when they took on merger or take-over operations, normally through borrowing. The «consensus»(3) of the analysts during this process did not question the model and they constantly adapted their estimates according to the results published by the companies.

  When the crisis began the direction of revised estimates was modified, this time downward. The analysts were caught by surprise by corporate results that were nearly always worse than their own estimates. Between the summers of 2007 and 2008 it was a slow and gradual process of recognizing a new reality but events that Autumn (bankruptcy of Lehman Brothers among others) speeded this up at a giddy and dramatic rate.

  The process took place at a critical moment last March. The «consensus» of analysts drastically reduced their estimates of profits for 2009 and 2010 from levels already very low just before the appearance of the first signs of an improvement in the situation in financial markets and some areas of economic activity. Later on, the downward revisions were slowed and for two months the S&P 500 led a very significant rally of 40%. This opens up the question whether there might already have been an episode of capitulation by the analysts that often precedes upward moves in the profits cycle, in the same way as extreme complacency often comes before the peak moment.

  Following the drastic cuts in recent months, at the beginning of May the «consensus» of the analysts showed forecasts that could be called conservative and even rather pessimistic under an scenario of progressive stabilization of the banking sector recovery of the economy as a whole. Specifically, for 2009 they expect drops of 12.4% in S&P 500 operating profit per share, a figure that would be much more negative if it were not for the base effect on the financial sector. For 2010 the forecasts for an increase in profits go as high as a notable 28.1%, so long as there is a general recovery of sectors as a whole and again with a substantial contribution from the financial sector. In spite of this figure, the expectations of the «consensus» for 2010 suppose a notably lower level of profits than that reached in 2007.

  If, as often happens,(4) the analysts have overreacted in recent months in lowering their estimates, it could easily happen that we shall soon see a new cycle of upward revisions, along with and, to some extent, strengthening the improvement in financial and economic conditions we are now beginning to see.

  This box was prepared by Fernando San José

  Financial Markets Department, ”la Caixa” Research Department

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