Corporate Profit Recession Is the Real Deal -- and CEOs Know It

The view from a CEO's 35th-floor office looks much worse now than things look on the ground floor.

That's for good reason -- while the economy isn't technically in a recession, corporate profits have likely entered one. There's a chance that this trend could continue for longer than expected -- and economists are concerned that the lousy outlook for corporate earnings could be what ultimately leads the economy into a full-fledged recession.

The stock market is lately discounting that the economic environment, while perhaps not improving in six months, won't get all that much worse either. But for companies, profit margins may continue to get squeezed, and the market may again be forced to readjust to this in coming months.

Right now, earnings estimates don't reflect this. Current first-quarter earnings estimates for S&P 500 companies call for a year-over-year decline of 7.8%, said Joseph Kalinowski, equity strategist at Thomson Financial/First Call. The second quarter is expected to drop 5.6% on a year-over-year rate.

But when the economy hits a recession, corporate profits (for the whole economy, not just the S&P 500) tend to drop 28% on average, according to David Orr, chief economist at First Union, looking back at all of the recessions since 1950.

Rising costs are currently hurting corporate profits most, especially at a time when the consumer seems to be plugging along at a pretty good clip. Among these costs are wages, medical and energy costs, and the inability for companies to pass those costs along to consumers. In addition, balance sheets are in lousy shape, as corporations took on increasing amounts of debt and now find financing difficult. Higher interest rates and lower stock prices make borrowing money more prohibitive. Business investment has plunged -- because companies no longer have the cash for it.

"The longer the sectors that are not getting clobbered still see profit margins squeezing from energy costs and labor costs, the risk that they will lay people off and do less investment rises," said Orr. "Until you get the capital spending supply-demand back into balance, I think it's hard to ignore the risk that this thing spreads."

Supply and demand won't come back into balance unless a combination of interest-rate cuts; a strong, ongoing rebound in investment and declining costs help improve margins. It may very well be that the Fed's interest-rate cuts will help spur demand in a way that it's not doing now. And its possible that gains in producer prices -- which as of last month were outpacing gains in consumer prices (meaning companies are paying more for goods than they're selling them for) -- will decline, reducing costs for companies.

CEOs aren't confident that this will happen. Their outlook differs dramatically from the relatively sanguine concerns of consumers. The Conference Board's most recent survey of business executives' confidence taken in January, shows confidence as low as its been since 1980. (The next survey is due out in April.)

And it's no wonder. Year-over-year corporate profits were up just 2.4% in the fourth quarter, according to the GDP data, and they wouldn't have been in positive territory at all were it not for the petrochemical and tobacco industries. Those sectors are likely to continue to show strong profits in coming quarters, but other industries that showed sharp declines could feel more pain for several more quarters.

For example, year-over-year earnings for electronics companies (that's technology) plunged 24.5% in the fourth quarter, after growing 30% for the same period a year ago. Over-investment in technology is likely to continue to hurt this area, suffering from overbuilding and a lack of demand due to the implosion of dot-com and telecommunication equipment industries. Among the other industries that showed sharp declines in profits were autos, steel and transportation companies.

"Earnings are going to be ugly for three quarters of the year," said Kalinowski. "If stock prices are going to trade six months prior to a turn in earnings, we may not see the market turn around until May or June."

If then.

Historical Tell

The pattern of the 1990-1991 recession is constructive. The economy officially entered a recession in September of 1990; S&P 500 profits for that quarter were up 8.4%. They fell into negative territory in the fourth quarter of 1990, and remained negative for three more quarters, hitting a trough during the second quarter of the year, when earnings dropped 24%. Third-quarter earnings fell 17.8%, even though the economy technically came out of recession in March of 1991.

Right now, the market is expecting something brief. But that recession was brief -- and the outlook right now doesn't consider that possibility.