If you ask your typical bull why stocks have rallied so hard lately, the answer you'll get is that the market is looking past the obviously grim present toward a much rosier future. The economy will turn, after all, setting the stage for a robust profit recovery in 2002.
But not everyone is certain that earnings will be all that swell next year. Even though history shows us that profits tend to rebound sharply out of an economic downturn, you have to go back only to the last recession to find a time when that wasn't the way it turned out.
Even though the economy troughed in the first quarter of 1991, earnings for companies in the benchmark
continued to deteriorate through the end of the year. It wasn't until 1992 that they began to grow again, and it wasn't until 1993 that they hit prerecession levels.
It's possible that we're set up for a similar experience this time around. And if we are, then stocks, already expensive by historical norms on a price-to-earnings basis, are due to get even more expensive, making any rally that much more tenuous.
Good News, Bad News
Economists and (to judge from the rally in stocks) investors both expect that this recession will, like the one in 1991, be on the mild side. Good news for the country, but not the stuff that those sharp profit rebounds of yore were made from.
"If this is a gentle, shallow recession," says J.P. Morgan equity strategist Doug Cliggott, "then a very modest profit recovery like in '92-'93 is likely."
Source: Standard & Poor's
Sharp recessions are like forest fires for corporate America, he says: destructive, but they clear out the underbrush and unhealthy trees that have been choking back health -- the Chauncey Gardner view of how the economy works. Inventories are worked off hard, capital expenditures get cut back drastically, labor gets shed violently, balance sheets either get healthy or they go away. Clearly some of those things have occurred in the current downturn, but nothing like in the deep recessions of the past. On the labor front, for instance, the economy has lost about 900,000 jobs since payrolls peaked in March. In the severe recession of 1982, nearly 3 million people got pink-slipped.
If we're not going to get the big blaze, then companies are still going to be dealing with a lot of dead wood at the other side of the downturn. Morgan Stanley chief U.S. economist Richard Berner thinks that one of the big problems for companies coming out of the recession will be how to deal with lingering excesses. He worries that too much production capacity will force many companies into an extremely competitive environment where even if sales are robust, "earnings aren't because margins aren't there."
Work It Out
The right thing for corporations to do would be to continue to work off excesses even as business improves -- like after the last recession, when companies continued to restructure and the labor market remained weak well into the expansion. The problem is that cutback worries tend to put consumers on edge. On top of that, notes Banc of America Securities equity portfolio strategist Tom McManus, after the longest expansion in history, Americans have 10 years' worth of stuff in their closets. Coming out of a mild recession, there isn't going to be a lot of pent-up demand. With consumers erring on the side of thrift, the initial stages of recovery could be on the slow side.
Both Cliggott and McManus think that S&P 500 earnings in 2002 will end up essentially flat with this year, once you clear out a one-time gain due to a planned accounting change. What's worse, they say the risks are decidedly to the downside: If we end up having something worse than a garden-variety recession, earnings will continue to slump through next year.
Struggling to find a silver lining in any of this, one can at least say that once the nasty times are all done with, companies will be lean and trim and poised for growth. But investors might have a longer wait than they want before all is well in corporate America's garden.