Poking Holes in the 2005 Profit Picture

If past is prologue, corporate profits could show little or no growth in 2005.

While few analysts have espoused this view, history shows that it could happen if economic growth decelerates as expected and profit margins decline from peak levels.

Official forecasts put earnings growth at 10.6% next year, down from about 19% growth in 2004, according to Thomson First Call. But the conditions for a much softer number could be in place.

Economists surveyed in the Blue Chip Economic Indicators newsletter recently predicted that gross domestic product would slow to around 3.5% next year from 4.4% this year, as consumer spending moderates amid higher interest rates.

Meanwhile, many analysts say very strong profit margins are unsustainable. Pretax profits as a percentage of gross domestic product, adjusted for inventories and capital consumption, were sitting at 10.1% in the second quarter, up from a low of 7% in the third quarter of 2001 and above the 35-year average of 8.4%. (Because tax rates change over time, pretax margins allow for more accurate comparisons.)

"The level is very high by historical standards and the run-up over the past three years is rare," said Ron Wexler, an economist at Merrill Lynch.

If a deceleration in profit margins and a slowdown in the economy were to coalesce next year, the implications for earnings could be profound. Whenever these two events have coincided in the past, profit growth tended to flatten out or even decline.

In 1989, for example, real economic growth slowed to 3.5% from 4.1% and margins slipped to 7.8% from 8.5% the year before. As a result, pretax profits fell 1.4% after growing 17.3% in the previous year. Data from Merrill show similar results on six other occasions over the past 50 years.